No Debt Plan

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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

I’m not above cutting coupons to save some money. I haven’t discovered many consistently good coupon sites. One I have enjoyed is Coupons.com. You have to install their special coupon printer software (no big deal), and off you go. I recently printed off 6 different coupons for things we use on a regular basis.

The only thing about all coupons is they are going to be for name brand items. Sometimes the retail price of the item minus the coupon is still more than an equivalent generic or house brand. If the house brand is just as good, why not use that?

Also, I know there are a ton of manufacturer’s coupons floating around out there. I haven’t found one site that works to print them all. Coupons.com usually has about 6-8 pages of coupons, each with probably 6-8 per page.

I did find GroceryCoupons.net the other day, but can’t get the site to work. I can view all of the coupons, but it says you have to login to checkout. Well, I’d love to login, but I can’t find how to register. I think I would have found it by now, but if you successfully use the site please let me know!

And if you know of any other large sites that don’t charge for sending you coupons, let me know.

I received a reader comment/question on The Savings Snowball. Instead of answering within the comments, I thought I would share it here and flesh it out a bit. Here’s the question.

But how do you separate what you’re saving for?

My bank lets me put the money into a savings plan (banking in Israel is different - we don’t have “savings accounts”, just savings plans).

What financial management system do you use to separate out what you’ve saved into various blocks?

Let me clarify how our savings work. We only have one savings account with ING Direct. All of our “saved” money goes into this account. (ING does give you the option to open up multiple mini-accounts to save for specific purposes, but we don’t use it.)

Instead I use Microsoft Excel to track what is in the account. We have a Excel Workbook for our finances, and each worksheet within it tracks one account (savings, checking, etc.). So there is a worksheet for the ING savings account. We then break down and track each category within the spreadsheet.

An example that is similar to what we use is shown to the right. The top 5 rows are what is currently in the account. The first line shows the total of the four categories below it. All of the money is in the one savings account, but we track it individually with the spreadsheet.

Below that, if we transfer money into the account, it goes towards a specific category. If we were depositing $400, it might be broken up as shown.

The grouping on the bottom is the new total… simply the first group plus the deposit group to give the new totals in each category. I then copy the numbers from the bottom row to the top row to complete the update.

That’s how we track everything. Excel is a very powerful tool if you can learn how to use it. Most of what we do is just addition and subtraction, so your average user should be able to handle it.

If you are trying to get out of debt you may have heard of the debt snowball. Essentially, you line up all of your debts and put all of your spare money toward the one with the lowest balance. After that one is knocked out, you go after the next smallest one. And so on until you are debt free.

We are using this same method for our savings method. Here’s how it works for us. (BluntMoney has also described her method for snowballing savings.)

1. Come up with a list of goals you want to save for. Some examples: funding a Roth IRA this year, having an emergency fund of 3-6 months expenses, or saving for a trip.
2. List those goals in order of either importance or date you want to have completed. For example, you may want to completely fund your Roth IRA this year, but you are also going on a trip. The trip has a deadline, so maybe in this instance it gets first dibs on your saved money each month. This will differ from person to person.
3. For each goal, there are two ways to determine how much you save each month. If the goal is ‘due’ by a certain date, then calculate the payment you need to make to yourself each month to reach the goal. If you want to save a specific amount each month, calculate how many months it will take you to get there.
4. At the end of every month apply your free cash flow (what is left after income minus expenses) and apply to the goals in order.

Here is how our Savings Snowball is currently set up:

1. Save $3,000 by the end of August 2008 for a trip to NYC this December. Payment: $200.
2. Save $3,000 by the end of July 2009 to cover excess MBA school debt (my company is paying for about 66%). Payment: $80.
3. Save $50 into our emergency fund. Payment: $50
4. Save as much as possible into Roth IRAs for 2007 and 2008. Payment: Whatever is left of the savings money.

We wanted to fund the New York trip a few months ahead of time to give us time to react to the cost. If the things we decide to do come out to be $3,400, we have a few months to save up that extra cash. Based on what we had already saved up, a $200 payment would have us finish by late August. We rounded up because $200 is a lot easier to remember than an exact amount such as $194.13.

With my MBA loan debt (in deferral), payments don’t kick in until after I graduate. There may even be a grace period after graduation, but I wanted to have the money saved up. Again, I calculated how many months were between here and there and came to a rounded number of $80 per month.

We have a goal for our emergency fund as well. However, since we already have at least a month’s expenses saved up we didn’t think putting the rest of our money into it made sense. A payment of $50 from us (plus all of the interest in our accounts, which is roughly another $50) will get us on our way.

The rest of the money falls into the Roth IRAs.

Let’s say we get to the end of the month and have $800 left over to save. According to our plan, $330 is immediately broken up and placed in the above categories. This leaves us $670 to put into our Roth IRAs. It’s pretty simple, but can be powerful once you reach a goal (just like the debt snowball).

Once our trip is funded, we suddenly have $200 of extra cash flow to apply to the next goal — saving for my MBA loans. Instead of placing $80 per month aside, suddenly we are dropping $280 into that category. This accelerates how soon we reach this goal. After that is fully funded, we move to the emergency fund, and so on. Some people will say the debt snowball is completely different from this. Or say I am doing this all wrong. That’s fine, but this works for us. If this were truly like the debt snowball, every last cent we save would go toward the first goal, then the second goal, then the third. I guess I’ve got it set up in the way I do with specific payments sort of like minimum payments on debt. It seemed silly to us to save everything for a vacation, and nothing for retirement, debt, or emergency fund.

The bottom line is you need to have goals for how you save your money. You have a 100% chance of not hitting a goal you never set. Do the math and see how much you can set aside each month for your goals. The next thing you know you’ve saved for that next car, or the down payment on a house, or for that special anniversary trip.

I received an e-mail from a reader with a question. I told him I would answer on here to open up the discussion to anyone else that wanted to bring in some input. This post is rather long, but hopefully there are some advice that is useful to you.

I have been following your blog and I have a question about one particular item that I have not seen you discuss.

How do you and your wife prepare for major purchases that you know are unavoidable?

Obviously you have an emergency fund for things that come up that you do not expect. But what are you currently doing for the things that you do expect?

The main item in question for me is cars. I know that my vehicle will not last forever, and I know what my plan is for replacing them someday. But I am just curious what your plan for that is. I will share my plan. It is Dave Ramsey’s idea, but I think it is a good one. Basically you invest the equivalent of a car payment into a good mutual fund for 5 years.

After that first 5 years there is enough money in that fund to pay cash for a good slightly used car, plus enough money left in there that will continue to accrue enough interest that you will never have to put any more money in it. Meaning that every 5-7 years the fund will have earned enough interest to pay again for a good used car. The only modification I plan to make is to put the money I get from selling my current car back into the fund. I believe this will allow me to upgrade every 5-7 years as well.

All this is to ask:

1. Do you think this is a good plan?
2. Do you currently have a plan in place?
3. And if you don’t think this is a good plan what would you recommend?

So, a lot to tackle here. Let’s break it down.

For expenses that are unknown, the reader is right. We have an emergency fund for unexpected costs (water heater exploding, flat tire, car/house insurance deductibles, etc.).

For anticipated expenses that are down the road, we try to budget it out as reasonably as possible. Are we currently saving for our next cars? No, but they are on the list. Here’s some examples:

• Saving for a ‘new’ used car - we would like to get to the point that we are consistently saving for this, even if it were $100 per month. Every little bit counts. Saving a full car payment depends on what your idea of a car payment is.
• Saving for new tires for our cars - I think it would be a bit overboard to save up a specific amount each month for new tires right when you buy a new pair. If our monthly cash flow is healthy, I may just eat the cost of tires in the month it happens. If not, we may spread the cost out over a couple of months. If I see the tires are wearing down and I can plan for it, I would share the cost over several months.

In regards to Dave Ramsey’s plan, this is how I understood it. Assume you have a car payment of $350. You pay off the car this month. This should leave you $350 next month to do as you please. Dave’s advice is to continue to save that amount every month, just like you had a constant car payment. When the time comes to sell your car, you’ll have enough cash on hand to purchase a new used one… and restart the cycle. That’s the plan I’ve heard.

As to the plan that was mentioned by the reader, I am a bit skeptical. Let’s run the math (link to Excel sheet I created). If you pay $350 per month to yourself and earn 0.67% growth per month after fees and taxes (8% per year / 12 months = 0.67%). Pay the $350 for 60 months, and you should have $25,888.35. Let’s take out $15,000 for a used car, leaving you with $10,888.35. (Of course, you would add the selling price of your previous car to that $15k as well, so you might not need the full $15k.) That principle is going to have to grow over the next five years to not only pay for the next used car, but also keep funding itself to buy the car after that. Running the math, the likelihood of that happening looks slim to none. It would work to buy the first and second car, though.

If you bump it out to seven years of payments and seven years between cars, the math is a lot more promising. It looks like you could pull it off. Really, in the end, if you have enough in an account that earns a consistent return, you would be able to estimate what your ‘income’ off of the fund would be. If that amount over your specific period of time is greater than the cost of a new used vehicle, then you’re golden.

However, you can only crunch numbers for so long before it starts getting really complex. You can’t factor in for issues like investment loss (or lower growth), inflation, taxes, or the value of the car you would sell. Well, you could, but it would be complex!

I would always be cautious in putting money into an account that I am going to need within a short time frame. I think five years is a relatively short period of time compared to retirement. Imagine putting your money into the mutual fund in 1999 and watching it lose a large amount of its value over the next few years. If you had to buy a car in 2001, you would be in some pain. If the money was in a more safe vehicle (bonds or a high yield savings account), I would be more comfortable, but then you are giving up possible investment growth (difference between what it could have grown and the yield on the account).

To answer the questions above:

1. Do you think this is a good plan? - I think it can work. It might be a little too risky for my blood. I would prefer a savings account for liquidity purposes. As JD at GetRichSlowly likes to say, “Do what works for you.”
2. Do you currently have a plan in place? - Actually, no. (Gasp!) Saving for a new car is on our savings snowball list (more on that later), but we are focusing on funding our NYC trip, emergency fund, MBA debt in deferral, and Roth IRAs currently.
3. And if you don’t think this is a good plan what would you recommend? Again, do what works for you. I don’t think it is necessarily a bad plan. It really depends on the cost of the ‘new’ vehicle, how much your investments really return, and a ton of other factors. The bottom line is awareness is a big step forward in this arena. Simply knowing that a car is going to be need to be replaced ahead of time puts you a step ahead in the game.

Many times in the personal finance world, we focus on the small things. Cutting coupons, getting 1% better rates on savings accounts, or using index funds to cut investment fees (and thus raise long term returns). This is all well and good; heck, you will see me saying the same things. The little things really do add up to become big things.

Ah, yes. Those bigs things.

Before you start focusing on the little things, focus on those giant, elephant in the room issues. Adding up many little things may add up to one big issue, but if you’ve got ten big issues to tackle then you are not helping yourself.

How about an example? It’s full of detail for a reason, so pay attention…

Jack brings home $2,700 per month after taxes. He lives downtown close to work, and rent on his one bedroom studio apartment runs $1,000 per month. His cable/internet bill is $150 because he just loves those movie channels. He usually spends $300 on groceries, and his cell phone is $100 each month (he just had to have the data plan for his Blackberry). Utilities usually run $150 each month as well.

Since Jack lives downtown, he walks to work every day. Yet he pays for a parking spot in his apartment’s deck, and keeps his commuter car there. His total car costs run him $500 per month.

Jack is a recent graduate with a heavy student loan load on his shoulders. His loan payments cost him another $200 per month. While in college he racked up some expensive credit card debt. He pays his minimums of $50 per month.

So it seems that Jack’s total expenses run $2,450 per month. His income is $2,700. Not bad, right? Jack is cash flow positive with $250 left at the end of every month. A little bit to save, a little bit to put toward retirement, or hey — pay down that debt!

Jack is a lucky guy. He seems to have discovered this new personal finance website called No Debt Plan. He reads it daily and has decided he wants to make some changes. Jack decides to definitely start cutting back in some areas and makes the following changes:

• He only puts regular gas in his car, and only drives if he absolutely has to. Otherwise he walks or takes public transportation. This saves him $10/month.
• He really goes after the sales at the grocery store . He tries to buy in bulk and make large meals so he has leftovers. This saves him $18/month.
• He cuts the heat down a few degrees, saving him $8/month.
• He calls his credit card company and successfully wins a reduction in his rate, saving him $5/month on his minimums.

He sits back, turns on the TV, and feels pretty happy with himself. He’s saved himself $41 each month just by these extra efforts.

But wait. Let’s look again. Jack has missed several big ways he could save…

• Cut his cable/internet package back. Get rid of the movie channels, and all the other extras. He could cut his monthly cost down to at least $100, probably $75. Savings: $50-75.
• Reduce the cell phone plan - get rid of the data plan unless work pays for it. Possible savings: $30.
• Jack probably does not need a car. If he stays in the city most of the time he can walk or take public transportation. If he needs to go out of town, he can always rent a car. This is an enormous savings of $500 per month.

The total savings from these ranges would be at least $580. Jack’s original $41 savings doesn’t sound that great in comparison. His focus on the little things has made him feel great about finances. Yet if he could make some serious changes (namely, getting rid of the car expenses), he could make some serious progress.

The bottom line: tackle the big issues in your personal finance life before you really focus on the small ones. It might even save you some effort from all that coupon cutting!

So we haven’t fully funded our Roth IRAs, but I’m giving away more than $23,000. That makes sense, right?

Well, thanks to ING Direct — it’s true! If you sign up with ING Direct through my referral, we both win. Here’s how I did the math.

• Your Initial Deposit: $250
• Bonus Deposit from ING (for depositing $250+): $25
• Total Principle: $275
• Assumed Interest Rate: 3.25% (current savings rate is 3.4%)

If you leave that $275 in the account without adding any money to it, in 30 years the account will have $729.04 in it. Take away your original principle of $250, and you’ve earned $479.

This assumes:

• interest rates won’t go back up to the 4%+ we’ve enjoyed until the recent federal reserve cuts
• you don’t add any additional principle; if you did, it would be obviously worth much more
• you don’t pay taxes on the interest earned each year (which is untrue, I’m just ignoring it for simplicity)

And just for disclosure sake: I’ll earn a $10 bonus if you sign up.

Setting up an account with ING is a great first step. ING makes it easy to setup multiple accounts so you can save for specific goals. Transferring money is easy. Customer service is great. I can’t say enough about ING. If you’re interested, just leave a comment with your e-mail address!

I am always looking for little ways to save money. You can save money by not spending it, or spending it more effectively. This post goes into the latter category.

I can’t remember how I came across FatWallet, but I’m glad I did. It is an all in one “deal” site. Users post up deals they find online such as coupon codes at specific retailers. Also, retailers register and will give a certain amount of cash back (through FatWallet) if you visit their site through FatWallet. This is designed to give consumers incentive to purchase, of course. However, if you are already planning on purchasing from the site it becomes an extra discount.

I’ve made three qualifying purchases so far. Back in November I decided I was going to refresh the hardware in our desktop PC. I always purchase parts through NewEgg. Through FatWallet, I can earn 2% cash back on my purchase. I did just that and earned $15.26 on $762.94 in purchases. I would have purchased the parts at NewEgg regardless of the discount, so this is just a nice bonus. On top of all that, I also get cash back on my credit card. Cash back coming from everywhere!

The only catch is you must wait a standard 90 or 120 days from purchase to claim your cash back. This is to insure you don’t purchase items and then return them, while keeping the cash back.

My third purchase was refurbished printer ink, but I’ll go into that purchase at a later date.

I’ve got $26.69 eventually coming back to me. Have you used FatWallet?