No Debt Plan

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IndyMac failed last week and has the great honor of jumping to 2nd place in the coveted list of “largest bank failures in the United States… ever.” The massive investment bank Bear Sterns was bailed out by the Fed and JPMorgan earlier this year. Fannie Mae and Freddie Mac are being propped up by the government as I speak.

There is a feeling of panic on Wall Street. For account holders at IndyMac bank, Monday morning was also full of distress.

Is your money safe? What if your bank went under out of the blue? Could you pay your bills, fill your tanks with gas, and put food on the table?

What’s the FDIC?

FDIC stands for Federal Deposit Insurance Company. They insure that the money you have in your bank account — up to a certain point — is guaranteed to be yours. As in, you can’t lose it if the bank goes under.

A quick example: you have a checking account and a savings account at ABC Local Bank. The checking account currently has $6,000 in it; the savings $15,000. ABC wrote some seriously poor mortgages, over-leveraged its assets, and is now going under as a business.

You walk to the bank in town one morning to deposit a check your Mom sent you for your birthday. To your surprise, the doors are chained shut and a notice is on the window. That notice informs you the bank is going under and the FDIC is taking over.

Is all of my money safe?

For average Joe American I’ve got to nearly say “Yes!” to this question. However, technically there is a limit. For each bank you hold accounts at, your money is insured up to $100,000. So unless you’ve got more than $100,000 in total deposits at that bank, your money will come back to you.

As a side note, the FDIC likes to take over banks on Fridays. This gives them time to settle into the systems over the weekend and insure a smooth transition on Monday morning for those account holders trying to access and withdraw their money.

The FDIC only covers checking/savings accounts, right?

Wrong. The FDIC will also cover IRA accounts up to $250,000. This was a surprise to me as I had always heard the typical $100,000 insurance protection mentioned. So if you also opened up Roth IRA with ABC Local Bank, your account is “safe” up to $250,000. Hopefully in the future you will have more than that, but that would definitely cover me personally right now. (I wish it weren’t so!)

I’m curious as to how that works with the IRA accounts. Are you able to roll over the holdings to a different account, say, one with Vanguard? Or do you have to pull the money out and reinvest? I’m guessing the former because the latter could make for a messy tax situation.

The Bottom Line

If you have less than $100,000 in various checking/savings accounts with a bank, your money is insured 100% by the FDIC.

If you have less than $250,000 in Individual Retirement Accounts at a bank, your money is insured by the FDIC.

If you have more than $100,000/$250,000 in the above accounts — what are you thinking? Walk across the street, open a new savings account with XYZ Local Bank and give them any money over $100,000 from your savings.

Can you do this with IRAs? That is, can you have three different IRAs with three different institutions, each with $250,000 in them? How many IRAs can you have open at one time? I’ll answer these questions tomorrow.

I’d love to be amongst the ranks of full-time bloggers like Get Rich Slowly and The Simple Dollar. Don’t get me wrong. Staying at home all day blogging and helping people get out of debt and create wealth… that’s right up my alley. (You’re helping me get to that point just by reading this article, so thank you.)

But! There are some benefits to keeping that full time job other than a little bit of security of a regular paycheck.

Company Paid Benefits

As a full-time employee you probably enjoy some of the following benefits that are provided to you by your employer: medical, dental, and vision insurance, life insurance, accidental death and disability insurance, and a pension or 401k.

All of that insurance is important. The retirement plan is also crucial.

There are catches to every plan and you’ve got to learn to navigate them. Is it better for you and your spouse to be on your insurance? Or is it cheaper (for similar coverage) to have each of you stay with single coverage with your employer? Single coverage is going to be cheaper than family every single time. Combining two single coverage amounts might be more than the family or spouse plan. So you need to run that math and look at what is offered.

You are probably familiar with most of the benefits above. If not, I’m going to cover them in another post in the future.

There’s A Different Kind of Benefit

A lot of people forget that brochure or piece of paper that human resources hands out when you do your new hire paperwork: work/life discounts. I know I did until we looked into buying a house. Suddenly I was interested in finding bargains everywhere!

What are work/life discounts?

• Would you like to save 10% on your cell phone bill?
• Would you like to save 25% on your new washer and dryer?
• Are you paying for the gym? What if you could get it for free?

These are some examples of work/life discounts your employer may be offering you. Often employers can negotiate with various retailers and vendors to get their employees discounts. These companies accept these discounts hoping they will make up for the loss in revenue with a large volume of corporate customers. These discounts can range from restaurants to dry cleaners to major appliances.

Can you tell what the difference between the refrigerators below is?

Other than price, there is no difference at all between the two fridges. This is the exact fridge we purchased last year when we moved into our first house. At the time it retailed for $1,499.99. Through my work/life discount program I purchased it directly from Whirlpool for $1,095 — a 27% discount or $404. It was delivered and installed for us (for a fee which we felt was worth it).

We were able to purchase a front loading washer and dryer from Whirlpool as well. We ended up saving over $1,400 before delivery, taxes, and installation charges on the three appliances. Even with those factored in we saved at least $1,000.

Thanks to my employer, I am also saving 10% on our cell phone bill. That essentially wipes out the cost of taxes and regulatory fees. Hey, $7 is $7. That saving for 12 months out of the year adds up to $84 per year.

Small Amount of Effort, Possible Large Payoffs

Just think of how quickly this can add up:

• Opting in to your 401k and getting an automatic 3% match.
• Saving $100 on life insurance by purchasing it through your employee plan.
• Saving 15% on your dry cleaning for the entire year.
• Enjoying significant discounts on major appliances like I did.

Each situation is going to be different; each benefit plan different. So ask your Human Resources representative for a list of your work/life benefits today and get cracking on saving some money. If you’re in debt, that extra 10% you save on your cell phone bill can be put in to your debt snowball. Remember, every little bit counts when you are trying to pay off debt.

I was planning on talking about buying a scooter to save on gas costs today, but I got an interesting comment yesterday that I felt warranted discussion.

The comment was left on my post about earning more than $400 in free cash back using my credit card. I said in the post that I think Dave Ramsey is flat out wrong for his anti-credit stance. Here’s the comment:

Nice try trashing Dave Ramsey for no reasons. I sincerely request to think twice before you trash him again. He is not preaching to cut plastic or get out of debt for normal people like me and you who manage debt prudently. His target audience is way over the head in credit card debt and their finance charges for one month is greater than your annual cash back from Amex Blue. For people like these it makes perfect sense to not use credit card. Think about it before you cash in your rebate check next time - Amex/Discover charge about 3% for gas station operator, you are paid 5% rebate for charge the gas expense to their card - guess what - the rest of 2% is paid to you from the 29% interest rate and insane finance charges and cruel penalties these credit card companies charge to people who are already in deep trouble. Pick up the documentary “In debt we trust” from the local library and open your eyes.

For starters, I’m glad this person commented on the blog. It opens up the discussion, and heck, I love getting opinions that challenge my own. So I am not writing about this to just rip this person’s argument apart or anything. I just disagree.

Dave Ramsey is a big name author and radio personality in the personal finance world. He went through very hard financial times in the 1980’s and has bounced back to make millions of dollars. He has written several popular books, and always tells his listener’s to stick with his “Baby Steps” to financial freedom.

Here are those baby steps:

1. $1,000 to start an emergency fund
2. Pay off all debt using the debt snowball
3. Save up 3-6 months of expenses
4. Invest 15% of your income into Roth IRAs and other pre-tax retirement vehicles
5. College funding for children
6. Pay off home early
7. Build wealth and give; invest in mutual funds and real estate

Now that all seems well and good on the surface. And I agree with the commentor’s point — Ramsey’s system is not designed to be used by me. I have a handle on our finances. His system is the life buoy thrown from the coast guard ship to the people on the sinking vessel who don’t know how to get out of their situation. I buy that.

And I am also not arguing against the point that his system gets people out of debt. It does. But, like any system, it has flaws and could be improved. I have three major beefs with his system.

First, Dave wants you to pay off all of your debt with the debt snowball. For those that are not familiar this is where he tells you to pay the minimum payments on all of your debt, and any extra money you earn or find gets applied to the debt with the lowest balance first. He claims that finance is 80% psychology, 20% money or something like that. Paying off a few small bills give you a psychological boost to tackle the big debt.

While that may be true, it is mathematically flawed and ends up costing you money. A simple example: you have two credit cards with balances of $1,000 and 3,000. Card A ($1,000) has an interest rate of 9.99% and Card B ($3,000) has an interest 23%. Dave wants me to keep paying 23% interest while I knock out the first card. That makes absolutely no sense and is costing me money along the way.

My second beef with Ramsey is that he wants you to do steps 5 and 6 before step 7. This isn’t a major concern of mine, but I don’t think children’s education should come before retirement. For some people, saving 15% will set them up for life when they retire. For others, not so much. You can’t borrow for your retirement. You can borrow for your kid’s education. Remember that.

The third concern I have with Ramsey is his anti-credit card stance. This is my largest issue with the Dave Ramsey system.

I understand that there are people out there in the world that simply cannot manage a credit card safely. For those folks, I have no problem saying you should use cash and debit cards for the rest of your life.

However, I don’t understand why Dave’s system starts with getting out of debt and stopping the use of credit, and ends with building wealth… but continues the theme of not using credit. If his system was there to truly rehabilitate people, he would train them how to safely use credit.

This may seem minor to some people. So you’re missing out on $400 of free money per year. Big whoop, I can deal with that. But there are many extra benefits to using credit cards and if the person following his system is truly following it to a T, then it applies just as well to credit cards as it does to cash and debit cards.

The bottom line for me is just because I have a credit card, I don’t have to use it to buy things on credit. Technically, yes, I do. But I have the money sitting in my bank account waiting to pay the bill. So use your credit card like a debit card or a wad of cash. It’s all the same. It’s a representation of money. Again, I’m not saying every person on his plan could handle it. Obviously many can’t in our country. However, I think one of the final steps should be to reintroduce people to credit in a safe manner.

There are so many benefits to credit cards it just seems silly. I’ve talked about them in the past. It helps automate our finances. I pay most of our normal bills with the credit card (electronically), and pay one bill to the credit card company (electronically) at the end of the month. I’m not sending ten envelopes with checks to various companies, trying to time them correctly so I don’t overdraw my checking account. I get security when I travel or buy things online. If my card is stolen, no big deal. American Express steps up to the plate and takes care of me. If I’m on my honeymoon in Mexico and someone steals all of my cash… well, that’s a different story.

Dave Ramsey is a Great Guy

Let me finish by saying I like Dave Ramsey. He’s a Christian influence in the personal finance world. He’s a huge Tennessee Vols fan. We have a lot in common. But I do think that his system — like any system! — has it’s flaws.

What do you think? Is Ramsey a nut case, financial genius, or something in between?

(Photo by The Joy of the Mundane)

Earlier this week our economic stimulus check finally arrived in the mail. My wife deposited it in our account yesterday on her way home from helping out at Vacation Bible School.

Originally, we had planned to stick all $1,200 of it into our emergency fund. That plan has changed up a bit. We’ve had some additional expenses crop up with getting a dog and we now need to purchase a larger crate. Our original crate was free from my parents, but Maggie is eventually going to out grow it.

We’ve also had a few other issues crop up that we would be paying out of pocket for regardless. Based on our estimates, we’ll end up saving $845 of the total. That’s right at 70%. It’s not as much as we’d like, but it is definitely a nice boost to the emergency fund, putting us way ahead of schedule to fully fund it with three months worth of living expenses.

Have you received your stimulus check?

What did you do with it?

I snapped the above photo a few weeks ago; the plastic bag bursting to the seams with $10.62 worth of spare change.

$10.62 may not seem like much to you. In the big scheme of things, perhaps it is meaningless. But our emergency fund now has $10.62 in it that originally was lacking. That’s ten dollars closer to our goal. Ten dollars if we find ourselves on the wrong side of an emergency.

People Are Lazy

Many people discount spare change, especially pennies. I love spare change. My wife laughs when I pick up pennies and nickels out of the road. “Do you know where that’s been?”, she always asks. Who cares? Free money!

When I worked at a movie theater in high school I knew guys who regularly threw away pennies. Into the trash. This always befuddled me. Why would you throw away money?

I can understand why people hate the penny. It’s weight is not worth its value. I’d rather have the weight of a quarter in my pocket than the equivalent weight in pennies. But it’s still money, right?

There was an instance at work that inspired this post. A co-worker had a lot of coins in the change portion of her purse. She dumped everything out on her desk with quite the jingle ringing through the air, then picked out the pennies. All told they numbered perhaps 55. She asked around to see if anyone would claim them.

My hand was the first into the air. Of course I would take them. I just earned 55 cents for doing absolutely nothing. Brilliant.

But now I had 55 cents. I, too, didn’t want to have it sit on my desk at work. What to do with it?

Hello, Mr. Coin Jar

For quite some time I have maintained a large mason jar for all of our spare change. In the past when we carried and used a lot of cash we regularly filled it up quickly. When the coins reached the top, we would dump them out, sort, and roll them before taking them to the bank. (Banks get rather irked when you walk in with $100 worth of completely loose change.)

However, since we use our credit card for every purchase possible, the level of coins has stagnated. I would bet we haven’t added more than $2 in total change in the past year to the jar.

That is until my 55 cent windfall.

Small Instance Inspires Action

As with many things in life, this small event inspired me to action. We added the 55 cents to the jar, then did our routine. Time to dump, sort, and roll. As you can see from the photo above we only had enough coins to wrap the pennies - I think we had 5 50 cent rolls.

The rest of the change had been sitting there, worthless to us. I counted it up separately and listed it in the card I put in the bag. Off to the bank — $10.62 added to our account then transferred to our emergency fund at ING Direct.

This goes hand in hand with snowflaking, an idea popularized by paid twice. You look under the couch cushions, in the street, in the closet… anywhere you can find money (or sell items for money) to get out of debt… the better. This is a perfect example. If we carried debt, we just snowflaked $10.62 toward the principle.

For those out of debt, this can be a great boost to whatever your current savings goal is. Again, $10 may not seem like much. What if you have $50 in change sitting around the house? Or $300 worth of items you don’t need or want and can sell?

Every little step counts.

Even little events can inspire great changes.

What steps have you taken lately?

What events have you ignored?

I got an e-mail from ING Direct’s Corporate Relations Department:

I’ve been following your blog for quite some time now and wanted to reach out and introduce myself. I’m a part of ING DIRECT’s Corporate Relations team and am fortunate enough to be responsible for researching and reading various personal finance blogs. I say fortunate enough because even when I go home at night I find myself following certain blogs on my own time! Before anything else, I wanted to commend you on the job well done with your blog; it’s creative, fresh, and informative.

As you may know, the two things at ING DIRECT that we take most seriously are Customer security and satisfaction. Our IT Department is always looking for ways to make sure our Customer’s banking experience is as secure as possible. Despite being named America’s “safest bank” by the Berkeley Center for Law and Technology at the University of California at Berkeley we wanted to take our security one step further – after all, you rarely hear someone complain that their bank is “too safe!”

We partnered with Trusteer Inc. to offer their Rapport consumer identity theft protection software – completely free of cost. I won’t bore you with details (they can all be found in the attached press release), but will provide you with a direct link to the offer on our site: http://home.ingdirect.com/privacy/privacy.asp?s=Promotions

Thanks for your time Kevin keep up the great writing!

Pretty sweet, and they are offering that free ID theft protection software on the site now. Check it out!

I’m not sure if ING sends these out randomly, but it sounds interesting. And hey, if you work at ING Direct, tell all of your customers about this site!

(Photo by Refracted Moments)

Yesterday we discussed why the government thinks giving you and I “free money” is a good idea. Today, I’ll show you three superior alternatives to spending that money on a flat-screen TV.

Pay down your debt

This is by far the absolute best thing you can do if you currently have debt. Spending this money is good for the economy, but you going bankrupt isn’t helping anyone. The faster you pay down debt, the faster you will be free to do as you please with your finances (to a point, of course).

Let’s say you have credit card debt at an interest rate of 14.9%. Your principle amount is $10,000 and you pay $200 per month towards your principle and interest. If you just paid $200 each month, it would take 78 months (six and a half years) to fully pay it down. You will also pay $5,717.39 in interest, or 57% of the original value of whatever you charged on your credit card.

If you pay down the principle with your $600, you will finish payments in 70 months and only pay $4,798.60 in interest. Interest saved? $918.79.

Start or Continue Saving

You need to have an emergency fund for those rainy days where you go to bed thinking “What else could go wrong?” Having money saved up for those days when everything goes wrong — your transmission dies, the cat needs surgery, and your washer started leaking heavily.

Use this rebate for that purpose. Open up an online savings account — we used to call them high yield until all of the rate cuts slashed interest rates down to pitiful levels — and don’t touch the money until you absolutely have to. I recommend ING Direct. If you already have an emergency fund saved up, start saving for that next big purchase like your next used car or the down payment on a house.

Even though the fed is going to cut the rate today and online savings account isn’t a bad place to have the money. I prefer savings accounts to CDs because if you are just getting started with saving it makes the money accessible for when you do have an emergency. You don’t sacrifice interest with a savings account. If your funds were in a CD — well, most CDs anyways — you have to give up 30, 60, or 90 days of interest if you pull the money out before the maturity date. Savings account general accrue interest daily, and there is no penalty for withdrawing some or all of the funds.

Start or Continue Investing

If you’re to this option, congratulations. You should be living debt-free and you’ve saved up an emergency fund. Maybe you’re just getting to this stage. Maybe you’ve been investing for the past ten years. Either way $600 may not seem like much.

However, invested in a broad diversified portfolio that earns just 8% for 30 years that $600 turns into $6,037. Earn 12% annually and you end up with almost $18,000.

Stick that money into a Roth IRA and see what happens when you retire.

Long Story Short

The government wants you to blow the rebate check on things that will boost the economy. They want you to spend, spend, spend. Don’t buy that. Use this “free money” as an opportunity to get speed up your No Debt Plan. If you’re still in debt, pay it off. If you have no debt, build an emergency fund or save for something else. If you’ve done all of the above, then consider investing it.

It’s all about the mentality where any extra money that comes in — tax rebates, bonus checks, or raises — doesn’t lead to lifestyle inflation. It isn’t easy, but it is worthwhile.

(Photo by Fleur-Design)

Starting this week, millions of Americans will be receiving tax rebate checks ranging from $600 to over $1,800 depending on how many kids are in your household. The government is hoping that you and I will take those ‘free’ checks, run out to Best Buy, and buy a LCD flat screen television. Today I’ll discuss why the government thinks that is a good idea. Tomorrow I’ll tell you what we’re doing with our check, and show you options of what you can do with yours.

Why does the government want me to spend $1,200?

I’m currently enrolled in an economics class in my MBA program. We discussed the rebate checks during the macro economics portion of the class. I will try not to get too technical and leave things easy to understand. For you economists out there, cut me some slack as this isn’t a lecture!

In an economic sense, any economy’s output runs off of these three things: consumer spending, investment, and government spending. Consumer spending is where you and I spend our hard earned dollars. It is affected by taxes and income (higher taxes or lower income = less spending = less output, and vise versa). Investment isn’t the type of investment you and I discuss regularly. This investment is capital investment. In a business sense, building factories, buying equipment, etc. Government spending is… where the government spends money.

Increasing spending in any way induces varying levels of a multiplier effect, dependent on what the increase was based off of.

For example, imagine the government decides to repave every single interstate in the country. They borrow (or tax) money, and jobs are created. Perhaps a new department is formed, which employs people. Workers are brought in to do the repaving. They earn money, and spend it in the grocery, video game, and hardware store. Those stores employee people, who get to keep their jobs and earn money because of the spending of the repaving workers. They go to the grocery store… etc.

As I mentioned earlier, consumer spending is affected by income and taxes. The rebate checks are essentially a form of lowering taxes by giving money back to the population.

All of this hinges on the marginal propensity to consume…

What is the marginal propensity to consume (mpc)? Essentially it is how much of every discretionary dollar you will go out and spend. If I gave you $100 and you would normally spend $95 of it, your mpc is 0.95. So mpc is on a scale of 0 to 1.

Right now America’s mpc is very high. We are spending more than we are earning and end up with a negative saving rate. Our mpc is very close to 1.

So, the government is trying to boost the economy by giving you and I some extra money. An equal amount of boost could be given by increasing government spending, but tax breaks are far more politically popular. Because our mpc is so high as a country, if most people spend the money then the economy will be given a boost.

That’s a big if…

If America becomes fearful of a recession and instead saves a majority of the tax rebate, it will be a lot less effective. This would bring down mpc (at least for this transaction); the lower it falls, the less boost the economy gets.

So if you want to be a proud American, play along with the government and go spend that check. If that just doesn’t seem right to you, stick around.

Tomorrow I’ll show you how to be a smart American.

Christine recently commented on one of my posts with a question about The Concept That Changed Our Financial Life.

I am trying to wrap my head around this concept but can’t. Can you possibly explain it to me in a little more detail? Is this an emergency fund or is it in addition to an emergency fund and how do you not use the money?

I’ll be glad to try and explain it better. Sometimes I’m not the best with examples.

To answer the question, no this is not a use of the emergency fund. It could be, but we prefer the “safety” of having additional funds set aside in case of emergency.

Below I contrast how the average Joe earns, spends, and saves money to what we do. Average Joe is living paycheck to paycheck. Money comes in on payday and lasts the next two weeks — just in time for that next paycheck.

Joe finds it hard to plan or save any money because he is constantly worried about paying his current bills. If he lost his job, he would be in quite the pickle because more bills would be do soon.

We do things a little bit differently. We saved up a monthly “buffer” in our checking account. That buffer is equal to the amount of money you spend consistently each month. If your rent, utilities, food, etc. is budgeted to cost you $2,000 per month then you’ve got $2,000 sitting in your checking account. So on Day 1 of the month, you’ve already got that money sitting in your account ready to be deployed for this month’s expenses.

Throughout the month when you get paid, you don’t spend that extra money. You keep it in the account, but it’s as if you’ve put it into an envelope that says “Next Month” on it. You can’t open the envelope until the first of the next month. Any additional income you earn over your monthly expenses goes into your savings. Any money that you don’t spend on your expenses (say your utilities cost $17 less than you expected) also goes into savings.

How about another visual?

Step 1: The Beginning of the Month

You’ve got your $2,000 in the account ready to be spend on your expenses. The expenses are listed below, sort of like an envelope system. If you write a check on April 2nd for your electric bill, you lower the amount in the “utility” row. If you buy groceries on April 7th and April 21st, on those days you would lower the “Food” row by whatever amount you spent at the grocery store.

As you earn income throughout the month, it is “deposited” into the “Deposits for April” row. Remember, you’re not spending that money. You’re spending the $2,000 you already had saved. And you don’t have anything in the savings row yet either. That comes at the end of month.

Step Two: The End of the Month

At the end of the month your Excel spreadsheet might look like this:

1. You’ve earned more than you spent on the month — a good sign. You earned $2,500 this month, but your budget from last month’s money was $2,000.

2. Some of your costs were lower than expected. You saved $38.63 on a combination of spending less on food, utilities, and whatever else you had in your budget.

3. Note you still haven’t spent a dime of the money you earned in April. That $2,500 is sitting up in “Deposits for April” ready to be turned into next month’s budget.

Step Three: Re-fill the Budget Categories

Now all you have to do is distribute the money you earned in April for May’s budget, as seen to the right.

1. Note that the total amount of money in your checking account hasn’t moved. You are just moving it from one place to another on a spreadsheet.

2. You’ve taken $2,000 out of your April deposit money (originally $2,500) and distributed it throughout your budget. $800 here, $300 there, etc. This leaves you with $500 left over from the previous month — a healthy amount.

3. You’ve also dropped that extra money you didn’t spend in April — $38.63 — to the To Be Saved line. You would add the $500 income left over as well to this amount, and apply it towards your savings goals.

And that’s that. You just went through a whole months worth of budgeting.

The hardest part of this whole concept is getting a month’s worth of expenses saved up. It could take a while to save $2,000. In the example above, it would take 4 months if you consistently earned $2,500 per month. Once you’ve got the money saved up, keep it in your checking account (we use ING’s Electric Orange, so we earn interest on it). As money comes in, it doesn’t touch the budget until the next month.

Following this concept will also make your life a lot more simple, at least in my humble opinion. We no longer have to time our bill payments based on when our paychecks will hit the bank account. We just pay the bill out of this month’s budget.

Christine, I hope this makes it a bit clearer to you. To use this concept, you’ve got to have a budget. You’ve got to know how much you can spend each month (the budget is the monthly maximum). Of course, if you spend less money, all the better. It drops to savings.

Readers, let me know if you have any questions. I’ll be glad to answer them via e-mail or, with your permission, use them on the site.

This is the sixth post in a series: The No Debt Plan.

Today we continue along the path to financial freedom. If you’ve made it this far, you should have a budget. Thanks to that budget, you’ve also achieved free cash flow.

Let’s put that cash flow to work.

Dave Ramsey recommends readers to save up $1,000 in an emergency fund, then knock out all debt, then finish saving up to 3 to 6 months worth of expenses.

Maybe that works for you, maybe it doesn’t. Let’s define an emergency fund first.

A Proper Emergency Fund

For Emergencies Only

An emergency fund is just that — a fund of money you have saved away specifically for unexpected, emergency situations. It isn’t to be used unless you absolutely cannot cover the expense in any way. Only true emergencies count — not having enough money to buy that new cell phone does not constitute an emergency.

Easily Accessible

You need ready, easy access to this money as well. I highly recommend you get an online savings account with one of the major players. We use ING Direct and it has worked fabulously.

I do not recommend you stuff it away in a CD. CDs do earn higher interest (usually) than savings account. However, the amount of extra interest is usually nominal. Additionally, if you have to pull the money out of the CD prematurely (before it matures), you lose most or all of the interest you’ve accrued. CDs are considered a “liquid” investment, but for our purposes it is not quite liquid enough.

If you’ve got the money sitting in an online savings account, you earn interest for every day it’s in the account. Pull it out today to pay that ER visit and you don’t sacrifice the last few months worth of interest.

Still Earns a Return

Technically you could leave your emergency fund stuffed between your mattress and box spring. That would be extremely liquid, even to the point that I could steal it from you if I knew where you kept it.

The major problem with the mattress plan or anything similar — think a regular checking account that earns no interest — is the money will lose its value over time to inflation.

This is not the time for a full blown economics lesson, but here’s how inflation hurts you. You start the year off with a dollar under your mattress. The cost of living goes up 4% throughout the year. At the end of the year, you still have that wrinkled George Washington waiting in the wings. But good old George only buys you 96% of what it did the year before. Continue on for several years and that dollar isn’t worth close to a dollar.

Hopefully your emergency fund is more than a dollar. This amplifies the point. Your stash of many dollars won’t be worth as much at the end of the year. So it’s best to earn as much reasonable, safe return as you can with the emergency fund… while also keeping it liquid. That’s why ING is such a great deal. I can transfer money in and out of the account, and as it stands today, still earn 3% on my money.

Of course I’ll pay taxes on that 3% interest, so if inflation really is 4% I am still missing out. But I’m doing better than just sitting on the money at home.

How Much Do You Need Saved?

Unlike Ramsey, I’m not going to put a dollar or monthly figure next to what I think you should have for an emergency fund. Climbing out of debt is of the utmost importance, but you do need some money set aside for the inevitable moments of life.

To steal a line from JD, do what works for you. If you are comfortable with $500 as an emergency fund use that as your benchmark. If you are extremely conservative then six months may be for you. We personally target 3-6 months of expenses. Six months would be great, but it is going to take us time to get there. If you are stuck in debt, I would encourage you to save up a little and then keep plowing the rest of the money toward the debt.

What do I do?

We’re currently at about two months. The upcoming government giveaway of $1,200 ($600 + $600) will bolster this up to three months. On top of that I should be getting a bonus from work which will add another half month or so to the fund. Once we are there we’ll feel pretty comfortable. If we had an extreme emergency come up, we could cut off our Roth IRA contributions and extra mortgage payments. For now, slow and steady gets it done. We’ll build up our fund over time without jeopardizing our other goals.

How are you progressing?

As mentioned at the beginning of this article, this is the sixth post in a series called The No Debt Plan. Where do you currently sit on the plan? Have you made it to the emergency fund yet?

Pre-Steps:

• #1 - An Honest, Positive Attitude
• #2 - A Long Term View
• #3 - Goals

Steps:

• #1 - A Budget
• #2 - Achieve Free Cash Flow
• #3 - An Emergency Fund