A while ago I gave a general review of Dave Ramsey's 7 Baby Steps, and before looking at the plan talked about why it is so important to prepare yourself for the whole experience of getting out of debt. You need to be ready to change your lifestyle, be ready to commit to no more consumer debt. It is a complete lifestyle change when getting out of debt, and you have to be ready for people to think that you're a bit off – that you're not acting normal. Cause you're not!
One of the most important parts of getting out of debt is preparing yourself for the process and planning ahead to make sure that you don't go further into debt – or negate any gains that you may have made. In Ramsey's plan it would be baby step 1 – saving $1000 for a small emergency fund. No matter what plan you're using, however, you should probably start by saving up a small emergency fund of some size. I think Ramsey's plan has it right, however, that saving up $1000 should be more than enough.
$1,000 To Start An Emergency Fund
Once you're current with your creditors, the first thing you should do before doing debt reduction is saving a $1000 emergency fund.
What's an emergency fund you ask? An emergency fund is your umbrella for when those rainy days come. Rainy days could include a good number of things:
- Car repair
- Emergency room visit or other unplanned medical incidents
- Unplanned travel expenses (funerals, weddings, etc)
- Job loss
- When you don't have enough for occasional expenses (like car insurance, property taxes)
You WILL Have Unplanned Expenses
Murphy's law says that “anything that can go wrong, will go wrong“. When you're trying to get out of debt, small things do tend to go wrong, and if you haven't planned ahead with an emergency fund, those small things can quickly turn into bigger things.
Money Magazine gives a statistic about unplanned expenses:
Money magazine says that 78% of us will have a major negative event happen in any given 10-year period of time.
Ok, let's look at that figure again. 78%! A majority of us will have a major negative event in any given ten year period! Even if you haven't had that major negative event, I'm sure probably 100% of us have had those minor negative events pop up from time to time.
My wife and I had one of those major negative events last year when my wife went into the hospital for 3 weeks. We incurred upwards of 250,000 dollars in medical bills. Luckily we had good health insurance and most of the costs were covered. We had also already started Dave Ramsey's program, so our total out of pocket cost was covered by our emergency fund that we had already saved up! Our situation last year is a great reason why emergency funds are such a good idea.
Why $1,000 For The Emergency Fund?
When it comes time to save up the emergency fund a lot of people wonder if $1000 will really be enough. My opinion is that it is. Most small emergencies will be covered by $1000, and only some major life events or other problems won't be covered. Some people will still opt to save up a bit more.
My wife and I saved $2000 in our emergency fund because we felt a little safer having just a bit more in the bank. It turns out it was a good thing we did because our out of pocket medical expenses for my wife's hospital stay were $1800. Granted, our situation was a major one, most unplanned expenses won't be that big.
Is $1000 Enough? Maybe
So the question remains, “Is $1000 enough for a small emergency fund when going through debt reduction?”.
I believe that in most cases it is, yes. Figure out for your family if you think $1000 will be enough. Look at your circumstances, how many children you have, job circumstances, etc and decide on a number. Just make sure that you don't set too large a number for that small emergency fund because you can start short-circuiting your debt reduction plan if you try to save too much at first when that money could be going to debt reduction.
Make Sure To Keep Your Emergency Fund Available
When it comes to where you should put your emergency fund, I think it's a good idea to make sure that you're keeping it in a place where you'll be able to access it quickly. Some good alternatives:
- High Yield Savings Account: Put it in a good high yield savings account like the ones at Capital One 360 or Ally Bank. Capital One 360 even offers some very flexible sub-account options so that you can split money up into different categories. (like emergency fund, vacation fund, summer camp, etc). This is what we've done.
- Money Market Account
- Local bank branch
The key here is to keep your money accessible and liquid, in case you have one of those emergencies where you need to get the money quickly.
Places I would not suggest putting your emergency funds include CDs, stocks, real estate, or other investments. Keep it somewhere you can get to it in a short period of time. The purpose of this money isn't to gain a ton of interest, but instead to insure you against unplanned events.
Do a Quickie Budget
After deciding to change, and starting on your emergency fund, it's probably a good idea to do your first budget. John Maxwell said:
A budget is telling your money where to go, instead of wondering where it went.
That quote is so true. If you're not telling your money where to go (into an emergency fund), it will just disappear. Write up a budget, figure out what your income and expenses are, and then assign every surplus dollar a job.
If you need to sell things on Ebay, get a second job, or sell your sacred comic book collection, just do it! Crank it out and get that $1000 saved!
How much are you saving for your emergency fund? Do you think $1000 is enough?