Posted: 13 Sep 2011 01:00 PM PDT
One common question I get from readers relates to the size of their emergency fund. Simply put, how big should it be? How much cash should they have saved in their savings account for those unexpected events life deals you?
Before we even get started, it’s important to note that there are a lot of different theories and ideas about how big an emergency fund should be. The ideas that follow are largely based on my own experience and from the many stories that readers have shared with me over the years.
Also, never, ever have an emergency fund that consists of a credit line. Your credit card is not an emergency fund. A line of credit is given to you by a bank and they have the power to revoke that line of credit or reduce it, often at the very moment when you’re facing an emergency and need that money. Do not rely on it. It is not an emergency fund.
First of all, no matter what your situation, you should strive to have $1,000 in your savings account. If you’re trying to pay down debt, switch to minimum payments for a while and build up this level of cash on hand.
$1,000 covers the vast majority of the emergencies we face in life. It can handle most car repairs. It can handle many medical emergencies, particularly if you’re insured with a deductible of $1,000 or less. It can handle lots of smaller situations that you didn’t quite expect.
If you have high-interest debt, pay that off before building your emergency fund beyond $1,000. I would define high-interest debt as being any debt with an interest rate above 10%. If you are carrying a debt with an interest rate at that level, you need to get rid of that debt. It’s seriously hurting your finances if you let it continue to sit there and accumulate interest.
If you have only low interest debts, I would move that emergency fund up to two months of living expenses for your family. I would consider two months of living expenses to be the base level of money I would keep in your emergency fund.
What exactly is two months of living expenses? Sit down with your checking account and figure out how much you spend in an average month. The best way to do this is to add up all of your spending over the last year – all of it – and divide by twelve. That will give you your average spending for a month. Multiply that by two and you have two months of living expenses.
Of course, if you’re ever in a desperate pinch, you’ll probably cut your spending somewhat and the money will last longer than that. That’s fine, but you never want to assume how your future self spends money.
If you have dependent children, I would add another month of living expenses to your emergency fund for each dependent child. Of the items here, this is the one that I would most describe as personal opinion. Simply put, when you have young children, you need to do what you can to maintain a stable household for them. Children thrive in a stable environment. One big tool for maintaining that stable environment is a very healthy emergency fund.
Don’t invest your emergency fund money into anything that might lose money. Many people are disappointed in the returns that a savings account gives and want to put their money into other investments with a higher potential return. However, investments that offer a better return tend to lose one (or both) of the two key factors that make savings accounts perfect vehicles for emergency funds. Savings accounts don’t have the risk of losing money over time (often at the moment when you need the money) and savings accounts are highly liquid, meaning you can withdraw the money whenever you need it without penalty.
Yes, stocks might outperform a savings account over a long period of time, but on a given day, stocks can very easily be down significantly, which means that you may not have adequate resources during the very emergency when you need it. If you put money into something like CDs, where you’re not at risk of a loss and get a better return, you face the liquidity problem in that you can’t withdraw the money without penalty at the moment you need it. Stick with savings accounts for this purpose.
When you do choose to use your emergency fund, your first priority should be to replenish it once you’re back on your feet. This might mean turning off other savings plans or investing plans for a bit as you replenish, but this needs to be done as quickly as possible to protect yourself against subsequent emergencies.
Posted: 13 Sep 2011 07:00 AM PDT
Instead, it makes it possible for you to get rich.
Lately, I’ve read statements in personal finance books where people claim that “frugality won’t make you rich.” They make the valid point that if you cut out some small thing – say, a $5 daily expense – you wind up with less than $20,000 after ten years.
“What good is that if it brings you misery?” they ask. “It can’t possibly make you rich!”
They miss the point. Frugality itself doesn’t make you rich. Instead, it increases the possibility of getting rich through other means.
Let me explain what I mean.
Joe Average has $80,000 in student loan debt, $25,000 in credit card debt, and a $10,000 car loan. His total monthly debt payment is about $1,200 and he’s going to be making those payments for the next, say, ten years.
Joe has dreams of starting a small business. He realizes that his monthly debt payment is really hindering his monthly cash flow and making it impossible to make the entrepreneurial leap that he wants to make.
He also correctly realizes that simply being frugal won’t give him the steady savings he needs to make the leap either.
Instead, he recognizes that frugality can help him get rid of that debt a lot sooner, save himself some serious money on interest alone, and get him in the right place to make his business leap much earlier.
Joe starts cutting out some of his lattes. He cancels Netflix and his satellite radio service. He starts making meals at home. He doesn’t pull anything out of his life that would be too devastating and instead feels good about the changes.
He manages to add about $250 a month to his debt payments.
His entire debt load is gone more than two years ahead of schedule. Because of frugality, he’s launching his business two years earlier than he might have otherwise been able to. Those are two years where Joe is at his youngest, so he’s able to throw a ton of energy into that business and make it a real success.
Frugality doesn’t create riches. It creates opportunity. Frugality enables you to pay off debts more quickly (and thus pay less interest on those debts). It enables you to increase your monthly cash flow. It makes it possible to reach a savings goal much quicker than you otherwise might have. Frugality can help you avoid going into debt at a tight moment in your life.
What do these things result in? They result in the ability to successfully launch a business. They result in the ability to go back to school and completely switch career paths. They result in the ability to take a lower paying job you’re passionate about that might blow up into something big. They result in the ability to jump on board at a startup company because you don’t fear your financial situation. They result in the ability to buy a house or buy a car. They result in the ability to start investing for retirement or for those big plans you have in the future.
Frugality frees real people to do these things.
The people who write about how frugality doesn’t really help haven’t faced a situation where a lack of money or the state of their own finances have kept them from doing what they want. That’s a reality I’ve faced many times in the past, where my finances have kept me from something I dreamed of. Frugality was often the key that opened the door.
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