Personal Finance 101 - The Fully-Funded Emergency Fund
This article is the third part in my series on Dave Ramsey’s Baby Steps, a proven personal financial plan. My goal is to explain a really solid money management plan in plain ol’ English, for intelligent yet financially “average” home managers.
The third step with Dave Ramsey’s Steps is to fully fund your emergency fund. This is probably the easiest step to understand, though it’s not the easiest to actually DO.
If you’re on Baby Step #3, this means you’re debt-free. And when you’re debt-free, it’s a lot easier to start spending money on the little things that really add up, be it worthwhile things like a family vacation. You write your monthly budget, and you don’t owe money to anyone, which means you see a lot more dollars on the income side. But don’t let it slip through your fingers. Pay yourself first. This will be your cushion between you and Murphy, your guarantee that you have absolutely zero excuse to ever take out debt again.
How much should I have in my Emergency Fund
Take note - a fully-funded Emergency Fund should be 3-6 months of your living expenses, not your income. And it should probably be the expenses you’d deem important during a true emergency, not your everyday expenses when life is normal. Ask yourself what you’d pay when you were suddenly facing a job loss. You’re probably looking at your mortgage or rent, utilities, groceries, gas, internet service, and phone service (or just your cell phone). If you’re in the midst of a true emergency, you probably would cut out (or at least pare down) eating out, entertainment, major gift giving, and big purchases that aren’t life and death. That new dress can most likely wait until the emergency has passed.
With this info, let’s pretend using these low-end numbers:
- mortgage - $800
- utilities - $200
- groceries - $300
- gas - $150
- internet service - $50
- cell phone - $75
- TOTAL = $1,575
- $1,575 x 3 months = $4,725
- $1,575 x 6 months = $9,450
With these numbers, you’re looking at somewhere between $5 to $10K. If these were my numbers, I’d play it safe and aim for an even $10,000. Remember that every household is different, so you know what’s important to you. Play with your numbers.
What constitutes an emergency?
A job loss, major medical issues, a blown transmission, or some other unexpected event is an emergency. Christmas, prom dresses, and a weekend on the coast are not. It’s perfectly fine to save up for those things, but not in your Emergency Fund. Save for those separately, after your Emergency Fund is finished (this is called “sinking funds,” which I will write about soon).
Where should I park my Emergency Fund?
It needs to be completely liquid, which means you need to have instant access to it. Dave says a basic savings account is fine. This is what we personally have - and we also figured we might as well get a decent interest rate while it’s sitting there. I did some research and learned about online banks - banks that have no traditional building, they only exist in cyberspace. If that sounds kinda scary, you’re not alone, but millions of people use internet banks, and since we started, we’ve never looked back.
Because they don’t have overhead fees, they can offer much higher interest rates than your standard brick-and-mortar institution. As an example, our “regular” credit union currently offers a rate of 0.69% on their savings accounts. Our internet bank currently offers 3.40% on their savings accounts - not enough to build wealth, but hey, might as well make money while we’re banking.
So where do we bank? We use CapitalOne, which is renowned for its customer service. I’ve been amazed how easy it is to manage our accounts with them, so much so that it’s now our primary banking source. I highly recommend them. There are many reputable online banks - here’s a great resource for starting your research.
How long will this take me?
It obviously depends on your interest rate and how much you can deposit monthly, but if you were able to save $1,000 in an CapitalOne savings account that earns 3.40%, you’ll reach $10,000 in nine months. Sounds like a chunk of time. It’s worth it, though. Just think - your emergency fund will be set! You can then start saving for some fun things, and except for those emergencies when you have to truly dip into that fund, you no longer have to set aside funds for a “rainy day.” You’ve already done it.