I don’t mean to imply that Dave Ramsey is wrong about a lot things. Generally, his advice is very good, although it does tend to be a bit simplistic and one-size-fits-all. And there is a raging debate about paying off debt using the “debt snowball” method he recommends. But if there’s one thing that he gets 100% correct, it’s his “Baby Step Number One”, setting up an Emergency Fund savings account getting $1,000 in it.
Emergencies are certain to happen. Anything mechanical — such as a car, washer, dryer, furnace, air conditioner, water heater, oven, dishwasher, etc. — can break down. Roofs can leak. Pipes can leak. Computers crash and die. Pets need veterinarians. People need doctors. Or lawyers. Or bail. It’s not a question of “if?”, it’s a question of “when?”.
$1,000 might not be enough to take care of every emergency. Some emergencies will cost a lot more. But $1,000 will take care of a lot of the emergencies that will come your way. Even if it’s not enough, at least $1,000 is a start.
If you live paycheck-to-paycheck, if you earn just enough each month to pay your predictable bills and you have nothing saved in an Emergency Fund savings account, then you are unprepared for anything unpredictable … and “unpredictable” is part of the definition of “emergency”: an unforeseen combination of circumstances or the resulting state that calls for immediate action.
Maybe you think you can just use credit cards. Big problem: If you have no savings, and all of your income in a normal month goes to pay that month’s predictable non-emergency expenses, then you won’t be able to pay off the credit-card bill when it comes due the next month. That means the credit card will start charging interest — effectively increasing the cost of your emergency. As if the emergency itself isn’t costly enough, you want to add to it? If you can’t pay the minimum amount due on that credit card bill, then you’ll have compound interest working against you. This is bad. (Hint: compound interest should be working for you, not against you.) Also a problem: The banks can say “no” at any time, cancelling your card or reducing your credit limit as they see fit. When it rains, it pours, right? This also holds true for using a home-equity line of credit. If you’re living paycheck-to-paycheck, how are you going to pay back a home-equity loan? And again, you’re at the mercy of the bank: The bank can reduce or eliminate your home-equity limit at any time, and are likely to do that if you’re unemployed or if the economy shows signs of recession.
The smart thing is to be prepared. Now. Open a savings account at your credit union or bank and start putting something into it — $100, or $75, or just $50, or whatever you can — every time you get paid. Pay yourself first: Put that money aside before you spend any of your take-home pay on anything else. If you get paid twice each month, $50 from every paycheck will get you to your initial goal of $1,000 in less than a year. If you can set this up to happen automatically, so much the better. Keep putting that money into the account until you have at least $1,000. As you savings grow, you will enjoy the sense of well-being and security that comes from having a little something set aside. You will sleep better at night. One less thing to worry about. You can take care of a $1,000 emergency! As it says in The Richest Man in Babylon, “Soon ye will realize what a rich feeling it is to own a treasure upon which ye alone have claim.”
Once you have your $1,000 Emergency Fund, make sure you don’t use it for anything except a genuine emergency: an unforeseen combination of circumstances or the resulting state that calls for immediate action. Don’t give in to any temptation to spend it on anything else. Once you have met your goal of saving $1,000, it’s time to set yourself a goal of having $2,000 at the ready.
Sooner or later, that unforeseen combination of circumstances or the resulting state that calls for immediate action, i.e., the immediate spending of money, will happen. When it does, don’t borrow money by using a credit card. Instead, you “borrow” from your own emergency savings. Spend carefully, but take care of whatever needs taken care of. Then, as soon as you are able, you “pay it back” by making your usual deposits to your Emergency Fund every time you get paid, building it back up to where it was before the emergency, and then beyond that.
If you don’t have an Emergency Fund, why not?
If you think you can’t save $1,000, then think again!
You can work more. Work more hours. Get a second job. Mow grass. Wait tables. Flip burgers. Whatever it takes, get that money into your Emergency Fund.
You can spend less. Get a cheaper cellphone plan. Cancel your cable. Don’t eat anything you didn’t buy at a grocery store and cook at home. Whatever it takes, get that money into your Emergency Fund.
You can sell some stuff. Downgrade to a cheaper car. Turn some unneeded clothes into cash. Clean out the whole house and have a yard sale. Whatever it takes, get that money into your Emergency Fund.
The four paragraphs above are very important. Saving money and putting it into an Emergency Fund isn’t just a good thing because it prepares you to better handle an emergency. It’s also an exercise in living below your means, spending less than you earn. You know, “Do not save what is left after spending; spend what is left after saving.” Imagine your income is water flowing into a tank and your spending is water flowing out. If the water flows out as fast as it flows in, the tank will never get full. No matter how high the income, people who spend all they earn — people who are unable to live below their means — will never have wealth.
The same thing that builds your emergency fund is what will build your net worth. If your net worth is negative (your debts are greater than your assets), then spending less than you earn will allow you to pay off those debts. If your net worth is zero or not much more, then spending less than you earn will allow you to save and invest. Remember, the Emergency Fund is the first step.