Have you ever felt like Superman? When I was let go from my IT job, I felt like Superman! People would ask me if I found another job. The first week I would tell them, “No, I am painting my house.” The second week I would tell them, “No, the family and I have been at the beach a couple of times.” It was great telling people that I wasn’t looking for a job! I felt like Superman, but not because of my awesome strength or super-human abilities, which I have neither of, but because I wasn’t afraid or overwhelmed. We had a 6-months emergency fund in place! I could have done absolutely nothing for 6 months if I wanted to and still have the same lifestyle that I had when I was employed because I had a 6-month emergency fund in place. I felt like a superhero. (As a Christian, I attribute my not being afraid to knowing who holds my future. I thank God that he has blessed me with money and the desire to save.)
3-6 Month Emergency Fund
Once you finished paying off all your debt except your primary mortgage, the next step is to raise your $1000 emergency fund up to a fully funded emergency fund of three to six months worth of expenses. The money in your emergency fund will be so you never have to rely on credit again, even if you experience a job loss.
How do you know if you need three or six months of an emergency fund? If you’re single and have no one who is dependent on you, then you can save for a 3-month emergency fund. If you’re a dual income household, then three months for an emergency fund should suffice for you as well. If you are a single income household with dependents, then you need to look at having six months worth of expenses in your emergency fund. If both you and your spouse work for the same company, then you need to consider a 6-month emergency fund. The greater the risk is, the greater your emergency fund needs to be.
Your budget will tell you how much you need for one month of expenses. Take this amount and multiply it by three or six to determine what you need for a 3 or 6-month emergency fund. You will want to build up this fund with the same intensity that you had when you were paying off your debt. If you paid off your debt with intensity, then this step shouldn’t take you that long.
Your savings rate will determine how long it takes you to complete this step. Your savings rate is the amount saved each month divided by your take-home pay. (If you save $1000 and your take-home pay is $4000 a month, then your savings rate is 25%). If your savings rate is 10%, then this step will take you 27 months to have three months worth of savings in your emergency fund. If you are saving 25% of your income it will take you 9 months to get to three months of an emergency fund. If you’re saving half of your income during this step, it will take you 3 months to complete this step. (These examples ignore your initial $1000 that you already have saved.) Double these numbers for a six months emergency fund. You can see that it does not matter what your income is. The determining factor is your savings rate. Hopefully while getting out of debt you cut unnecessary expenses from your budget so you can get through this step as fast as you can.
Where to Save this Money
The money for your emergency fund needs to be liquid and in a conservative investment. A savings account or a money market account can be used. Go with the money market account since your rate of return will be higher. Don’t invest this money in an aggressive investment like stocks. When the time comes for you to use this money, you do not want the possibility of your investment being reduced by half if the stock market crashes at that same time. Put this money in a money market account.
Done With Debt/Credit
Once you complete this step, you should never need to take on any debt, but you shouldn’t have had to before this. Hopefully by this time you have already decided that you will cash flow all your purchases. No more getting into a situation where you need to borrow money. By this time, if something comes up and you don’t have the money saved for it, that means you do not need it.
Step 2 and step 3 take determination and discipline to complete, but once you complete step 3, you are in a position to start building great wealth. You are cash flowing your monthly budget, and you have a good chunk of money that is ready to be used for retirement saving, college funding, and paying off your house! You completed the hardest steps now, and you are one of the few who have no debt and have a fully-funded emergency fund. Make sure you do a little celebrating at this time. You get to feel like a superhero now.