Last time we looked at Baby Step 2, paying off all your debt using the debt snowball. You take your bills, rank them in order from smallest to largest, and proceed to pay them off with intensity!
To review, here are the 7 Baby Steps.
Dave Ramsey’s 7 Baby Steps
- Step 1 – $1,000 to start an Emergency Fund
- Step 2 – Pay off all debt using the Debt Snowball
- Step 3 – 3 to 6 months of expenses in savings
- Step 4 – Invest 15% of household income into Roth IRAs and pre-tax retirement
- Step 5 - College funding for children
- Step 6 – Pay off home early
- Step 7 – Build wealth and give!
Baby Step 3: 3 To 6 Months Of Expenses In Savings
Baby step 3 builds upon the baby emergency fund you established in baby step one, and takes it to the next level. In step 3 you are building a fully funded emergency fund of 3-6 months of living expenses. The reason for building up this reserve? With this reserve you’re building your safety net against major life events so that you never have to go into debt again.
When you have your 3-6 months saved there aren’t very many things that can happen that you can’t pay cash for outright. Lose your job? You’ll be able to cover the mortgage long enough for you to find a new job. Have to get unplanned surgery? Your emergency fund will cover your portion of the bill (make sure you have good health insurance!).
Emergency funds help you to get rid of the risk of unplanned for events, and prepare for the future.
Why Build An Emergency Fund?
Often times people think it’s just a waste to build an emergency fund that is so large. It just seems to be overkill. Why not use the money for something else?
Personally I can think of a lot of reasons why it’s a great idea.
- Things Happen: Unexpected expenses WILL come up, and it’s better to have planned for it than to stick your head in the sand. If you don’t plan for those things they’ll end up happening at the worst possible times. Your heat will go out in the middle of winter, or you’ll end up in the emergency room for an unknown allergy. I’ve realized more and more over time that emergency funds are necessary because life happens and small unexpected expenses WILL come up. When you have the money saved these things are an annoyance, but not the end of the world.
- Manage Stress: When you have an emergency fund saved, life is a lot less stressful. You don’t have to worry about what you’ll do if a negative event falls in your lap. You just pay to get it fixed.
- Risk Is Reduced: When you have an emergency fund (along with other things like health insurance, disability insurance and life insurance), you have a lot less risk of having a bad situation turn into a catastrophe. A medical problem won’t turn into bankruptcy, and a job loss won’t turn into a foreclosure. In other words you’re making sound decisions to plan for problems, before they happen. You manage the risk that comes along with those major negative events, and stop them from turning into life changers.
How Much Is Enough?
The decision of how much money to save in your emergency fund is one your family will need to talk about. The amount may vary depending upon your living situation, number of children, job stability and other factors. The baseline that Dave Ramsey speaks of is 3-6 months of expenses.
So if your family has a minimum of $3000 in expenses every month after cutting out all the un-necessary bills, your 3-6 months of expenses would come out to anywhere from $9000-$18,000.
How many months you save will be dependent on your situation. At our house since we like the peace of mind that comes with the emergency fund, we want to have at least 6 months saved, if not a little bit more.
- If you’re single and have a relatively low level of needed income every month, you may be able to get by with only 3 months of expenses.
- If you’re the only bread-winner bringing home an income for a family of 5, then you may want to err on the side of caution and keep a buffer of 6 months of expenses (or more).
- If you’re expecting a major life event in the near future (layoffs, surgery), you may want to start stockpiling cash in advance, and save even more than the 6 months if possible.
Where Should I Put My 3-6 Months Of Savings?
Where you save your emergency fund is really up to you. The only thing I would say about this is to make sure that you put the money somewhere that you can get at it right away if you need to.
My personal preference for a good place to save the money is a good high-yield savings account, like the ones offered by ING. Another option is to keep the money in a good money market account or at a local bank branch. Whatever you’re comfortable with, as long as the money is liquid and available quickly.
Don’t put your emergency savings in things like real estate, investments or other things that could be tied up for a while without you being able to get at the money. Keep it liquid!
Next Up: Baby Step 4 Invest 15% Of Household Income
Next time we’ll look at saving 15% of your income once you have a fully funded emergency fund. This is where the fun starts happening – when you’ve paid off your debts and you start saving for the future and building wealth!
Do you think saving up 3-6 months of expenses is enough? How much do you have saved in your large emergency fund?
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{ 7 comments… read them below or add one }
Even though it has always been important to be prepared like this, it is vital now. You don’t know what might happen. Thanks for sharing this.
Mirandas last blog post..Online Personal Finance Resources
We have 6 months worth of expenses. One thing that’s important is to revisit this number on a regular basis.
As our expenses and spending change, we need to make sure that our savings can still cover us as long as we thought!
Perhaps I’m too cautious, but I believe if you are the only income-earner in the household–whether single or married–six months should be what you’re shooting for; if you have dependents, your amount will be greater than someone single, simply due to extra people to feed/clothe/shelter.
A dual-income family (whether with dependents or not) might be able to get by on three months (although not ideal), because odds are pretty low that both income-earners will lose their income at the same time. Of course, your mileage may vary.
This is what I tell my readers. Have approximately half the year of expenses in your bank account!
Thanks
Completely agree with having 6 months expenses set aside. Once you do that, you also need to put it into a CD ladder to have access and keep it growing. Here is a simple “how to” if you’re interested :
RateNerds last blog post..How to build a CD ladder
Our goal is to have 2 years of emergency savings set aside. With the current economic climate our goal is to save as much as possible. I think 6 months is a good goal, but it can go quickly if one spouse loses a job and can’t find work for a few months. Also, a parent might need to go back to school or take a part-time job and the emergency fund could be depleted quickly.
The Passive Dads last blog post..Money Saving Tips From ehow Friends
I’m with RateNerd – laddered cds are great for part of the efund. Not all, though.
The laddered fund is great for a layoff – you will get access to a bit at a time, paying yourself a paycheck in essence. BUT – You still need to cover the “roof, car, medical” type of emergencies, so part of the efund still needs to be in a quick access, fully liquid account.