What is an Emergency Fund?
So you want to eliminate your debt and get rid of those credit cards. My question to you is how fast would you like to make this happen? Would you rather pay off your debt in three months or drag it out for three years? Of course you are going to pick the three month option or you wouldn’t be here. If you are serious about eliminating your debt, then you need to stop spending money that you don’t have on things that you don’t need and put money back for those emergencies that you know will happen.
When I first started living on my own, I didn’t drive a new and dependable car. As a matter of fact, it seemed that I was spending most of my pay check on car repairs. Of course I didn’t have an emergency fund, but the banks were so kind that they gave me a plastic card that I could use any time I had one of these car repair emergencies. It didn’t take long before I ran up a few thousand dollars, missed a payment, and started paying a 21% interest rate on top of late fees. For the next several years, I was paying interest and wasn’t able to pay off the loan.
This is a standard strategy that credit card companies use. The credit card companies don’t expect everyone to be able to pay their loans in time, and expect them to default to a much higher interest rate than they originally was getting when they signed up for the card. To avoid falling into the credit card trap, you need build an emergency fund to handle those emergencies when your vehicle breaks down.
Build Your Initial Emergency Fund.
How much you need to put back is entirely up to you depending on your circumstances. I recommend having no less than $500 put back for your initial emergency fund. Yes, that’s right, I said initial emergency fund. We are going to increase this amount later. For some reason, the more money you make, the more your emergencies seem to cost. As a rule of thumb, I recommend putting back 2.5% of your income as an emergency fund. For example if you make $20,000 per year, you should put back $500 ($20,000 x .025 = $500).
Now that you have defined your emergency fund, your first priority is to save that money and put it back where you will not spend it. This money is for emergencies only and not to be used for anything else. Being a little short on cash to buy a pizza on Friday night is not an emergency. Put the money some place where you can get your hands on it if needed, but do not put it somewhere that makes it easy for you to spend. Consider putting the money in a separate bank account across town, or if you live near responsible parent’s, hand them a sealed envelope to hold for you for emergency use only. Keep in mind that I did say responsible, don’t hand your money to someone that is having financial issues or you cannot trust.
OK, so you have your emergency fund built up and in a secure place. It’s time to for you to start paying down your current debt. I’ll cover paying off your debt in another section. As you work towards paying down your debt, let’s say that you have what we consider an emergency and your alternator goes out on your car. You take it to your mechanic and they say it’s going to cost $350 to fix your car. You don’t have to panic, because you have that covered with your emergency fund. The problem is resolved and you are on your way.
Wait, you are not down to $150 in your emergency fund so what should you do. The logical answer is to go back to building your emergency fund until you have the money put back in. In order to achieve this quickly, you need to put a hold on paying down your debt and only pay the minimum payments on those credit cards until you have your emergency fund, funded again.
Fully Funded Emergency Fund.
So things are going well, and you still have your emergency fund, and you just made your last payment on your last credit card. You are now financially free from debt, with the exception of a major expense such as a house. So what’s the next step you might ask. Well here it is, finish your emergency fund until you have put back three to six months worth of expenses.
Let’s say for example you have a family to take care of and you get laid off from your job or something happens and you are not able to work. You need to be able to provide the necessities for your family to live. This is what the fully funded emergency fund is for.
The amount that you need to put back all depends on your individual circumstance. Let’s say you are married and your spouse also adds to the household income, you may be able to get away with putting back three months work of expenses. On the other hand, let’s say your wife does not work outside the home, then will want to make sure you have six months worth of expenses put back.
Keep in mind that this is an emergency fund, and you should consider it your financial insurance policy. Don’t put the money where it is easy to get to for you to spend, it is for emergencies only. But also make sure you don’t put the money some place you can’t get your hands on it quickly when you need it. This money is not for investing, it is for emergencies. Don’t plan on using this money as an investment; it’s actually an insurance policy.
Now that you have your emergency fund, you can use that to your advantage to reduce some other necessary expenses. I have my emergency fund saved back, so I am now able to take a higher deductable on my medical insurance which saves me money every month. Instead of paying the higher premium on medical insurance, I can save that money and use my emergency fund in the case anything ever does happen.
I’m going to state the obvious, if you ever tap into your emergency fund, you need to quickly replace it. Put a hold on your investing, retirement fund, and paying that extra principle on your house. Take a step back, and rebuild that fully funded emergency fund to make sure you keep your financial freedom.