Knowing The Difference Between Emergency & Urgency!

Living In Financial Freedom

Unknown-3

Financial freedom is on everybody’s list of must-haves, or should be, because financial freedom allows us the attitude and resources to live abundantly in each stage of life, free of worry, anxiety or money concerns, to completely live out the full vision and goals of one’s life. Although financial freedom is defined differently among people, each definition  contains in it some basic common elements: Let’s take a look at those elements and how they fit into our lives. Common financial freedom elements:

  1. VISION for how you want to invest your time, talents and money
    • Answer the questions: Why am I here? What am I passionate about? What does my life plan look like? How can you pursue your dreams when you don’t know what they are?
  2. PLAN (budget) that supports your vision and quality of life you want to maintain
    • A budget is simply a plan for spending your money that is consistent with the vision you have for your life. It’s making a plan for using your money instead of wondering later on where it all went. Good budget meets a couple criteria:
      • You live within your means: Only spend money you have
      • It includes savings for your goals
  3. DEBT-FREE approach to everything we purchase
    • A debt-free approach doesn’t mean we NEVER use debt, but that we use money we have whenever we can and when we use debt, we prioritize the elimination of debt in our budget. A wise man once said: “The debtor is slave to the lender.” There’s no slavery in freedom.
  4. A bias toward SAVING
    • Savings must be a priority in our budget. How much do we need to be saving? Let’s start the conversation at around 15% of our take home pay. Why? Because we need to have three types of savings for future needs: We need an Emergency Fund for when life throws us a curveball. We need savings for Retirement and we need to be saving toward known future expenses, like cars, furniture, kids, etc. Adequate savings allows us freedom to act when we want to.
  5. An ATTITUDE of contentment with where you are, and gratitude for what you have
    • Don’t compare yourself to anyone else, but be content with where you are. Contentment brings peace and peace is a large component of freedom. Gratitude focuses our mind on what we have instead of focusing on what we do not have. Be grateful, always.

This blog post focuses on the savings component of financial freedom, specifically the Emergency Fund Savings, and how to build it and use it correctly.

Emergency Fund Savings – The Best Self-Insurance

Unknown

Emergency fund basics:

What is it? Savings set aside for immediate use in the case of an emergency. Essentially, it is the lowest cost self-insurance.

Where does it reside? In a safe, accessible location, like a checking, savings, money market account or any place that is quickly accessible.

Why do we need it? To self-insure against inevitable emergencies or disaster and prevent the build up of debt, worry or frustration.

How much is enough? Most experts suggest 3 to 6 months of expenses, and almost all suggest at least $1,000 to cover insurance deductibles or instant emergency needs.

What priority is the emergency fund? It is top priority, before retirement savings, college education savings for the kids or savings for a home or new auto. The first $1,000 is even more important than debt elimination!

For most people dedicated to financial freedom, building the emergency fund takes a little time but otherwise is easy and straightforward. So what’s the hard part?

Emergency Fund – The Hard Part

Unknown-10

The hard part for many people is not saving the emergency fund money, but determining when is the appropriate to use it. It is tempting anytime we save money to use it for something “special”or when you get “an offer too great to pass up”. But an emergency fund is different from any other type of savings we have. Emergency funds must be saved for true emergencies because it is this money that keeps up out of debt when a crisis occurs. Thus, we need to be very judicious in using the emergency fund.

Urgency vs. Emergency – Know The Difference

For many people, it is hard to determine the difference between urgency and emergency. They look at their emergency fund as ready cash “if something really good pops up.” This is the wrong way to approach the emergency fund, because there will always be a sale, or a special deal, or “any opportunity” to purchase, which can put you at risk when that real emergency unexpectedly shows up. Most sales or special deals use time pressure to get you to buy, so we have a sense of urgency to make the purchase or risk missing out on the deal. By definition, these situations are urgent…but not an emergency. The best way to ensure there is money available for emergencies is to develop and follow a set of emergency fund access rules. Literally, criteria that must be met to access the emergency fund money.

For me and my family, the emergency fund can only be used in four situations: Health, Home, Auto and Family emergencies. Let’s look at some situations in each of these categories that are true emergencies where we can use emergency fund money, or just urgent situations where we can not use emergency fund money:

Type Situation/ Opportunity Emergency or Urgency? Can Use Emergency Funds?
Home Leaky waterheater Emergency Yes
Tables – 75% off sale Urgency No
Broken window Emergency Yes
Health Broken leg expenses Emergency Yes
New yoga class on sale! Urgency No
New workout shoes Urgency No
Auto New cool rims Urgency No
Blown out tire Emergency Yes
New water pump Emergency Yes
Family Job loss Emergency Yes
Vacation Urgency No
Attend family funeral Emergency Yes

Having clear criteria for emergency fund use helps us discern in a time pinch whether or not fund usage is appropriate. Otherwise we risk using the emergency fund money on urgent matters like a sale or special offer and then we are left unprepared for when true emergencies arise.

Why All The Fuss?

Unknown-16Unknown-5

The fact is, each of us will experience significant emergencies in our lives. It is reported that each adult has a 78% chance of a real emergency in any 10 year period of time. So over the course of your adult lifetime, about 60 years or so, chances are you will have 4 or 5 real emergencies when you need to have the emergency fund ready and funded to help you through the situation. It’s not a matter of “if” you will have an emergency, but “when”, so we must be prepared.

What’s the best plan? Build and maintain an emergency fund, with somewhere between three and six month’s of expenses in it. Develop criteria for using the emergency funds and a process to access the account to ensure the fund is used for emergencies and not urgent, emotional purchases. Because, missing a great sale may feel like a missed opportunity, but not having money when an emergency occurs could put us in a financial bind and potentially lead us into debilitating debt. Financial freedom requires that we save and properly use an adequate emergency fund to self-insure against inevitable emergencies. Financial freedom is not easy, but it is worth it!

Want more help with your personal finances? Consider Dave Ramsey’s Total Money Makeover. Click on the link and SAVE!

The Total Money Makeover: Classic Edition: A Proven Plan for Financial Fitness

Save And Invest Money Or Pay Off Debt?

The question of which is most important, saving and investing money, or, to pay off debt, is much like the age old question: Which came first, the chicken or the egg? Cases for both answers have been convincingly made. For some, this question is easy and they pick either saving or debt reduction as first priority and do it. But to others, the lack of clarity as to the priority has cause them to pause, or even worse, caused them to not act on either priority. So where do you start to answer the question? I think it starts with understanding why we save or eliminate debt. We save and/or eliminate debt to obtain financial freedom. Financial freedom defers for each person, but it is rooted in having the resources to pursue one’s goals and dreams. This financial freedom allows us to be free from worry and concern over money and be free to achieve our long term goals.

Unknown-3

Financial freedom, in most circles, is predicated on four main principles, which include saving and investing to build wealth and eliminating debt. The other two core principles are living within a balanced budget and insuring against disaster. It is the first two principles, building wealth and eliminating debt, that sometimes get at odds against each other. Because many times, debt reduction and savings for investment compete for the same dollar in our budget. It’s a common dilemma that goes something like this: If I only have limited money available to achieve financial freedom, is the priority to pay off my debts or should I save and invest the money to earn a decent return? On the one hand, we have debt, the wealth killer that is to be avoided or eliminated as a top priority. On the other hand we have the need to invest to build wealth to fund our goals and dreams. Both actions are paramount for financial freedom. But which action is the MOST important? Which action comes first?

The Case For Eliminating Debt First

images-4

Debt is an obligation that assumes we know, and can control, the future, in that debt requires regular payments over time which we can’t 100% control. Job loss, natural disasters and health issues can interrupt future payments. Debt is also expensive. Here’s some examples: Home mortgages cost us 4% (Interest rate on the money borrowed) and it only gets more expensive from there: Car loans and student loans are between 3%-7%, and the worst, credit cards, cost anywhere from 10% to 25%. This means that the couch that we purchased on a credit card for $1,000 and made minimum payments on for many years ended up costing us about $2,400 in all. In essence, we had to pay a fee of $1,400 to borrow $1,000 for the couch. Ouch, that’s expensive. And in comparison to the return on money invested in most safe investments, like money market accounts, certificates of deposit or savings accounts, which only pay a percent point or two in interest at most, most debts are more costly than any safe investment return received. So one could argue that paying off our debts is the top priority.

The Case For Investing First

Unknown-14

Building wealth, another core principle in financial freedom, is about investing early and often and letting compound interest work over time. It is imperative to start as early as possible, so we should make saving a priority. In addition, the return on investment for  blue chip equity investments, like an S&P500 index fund, is higher (averaging over 10% per year including dividends over the past 75 years) than the cost of some debt that people carry, like student loans, home mortgages and car loans. So, it could be argued that it is better to invest the money than to use that same money to pay down debt which has a smaller return. In other words, if I can make 10% on my investment, why would I instead pay down debt that only costs me between 3% to 7%?

A trusted source for all things investing: The Street

 

What’s The Smart Decision For Financial Freedom?

unknown-1

The answer to the question: Should I pay off my debt or save for investment to build wealth?, is rooted in the current condition of the four main principles of financial freedom mentioned previously:

  • Live within a balanced budget
  • Insure against disaster
  • Building wealth
  • Eliminating debt

If you’re reasonably insured against disaster (have an emergency fund) and you’re living within a balanced budget, then eliminating debt is the top priority. But if you don’t have both an emergency fund or a sustainable balanced budget, then the priority shifts to getting those right before attacking the debt.  Let me explain a good way to approach it.

Step #1: Start an emergency fund. Do you have an emergency fund? If you have no emergency fund, then the first priority is to save up at least $1,000 in an account for emergencies. Why is this the first priority? Because an emergency fund is savings to PREVENT further debt associated with any unexpected emergency. It is self-insurance, a key component of financial freedom. We’re not done with the emergency fund quite yet. More on this later. To recap, the first priority is to establish an emergency fund if you do not have one.   If you already have $1,000 saved in an emergency fund, or better yet, your emergency fund covers 3-6 months of expenses (discussed later) then skip this step and go straight to step #2.

Step #2: Eliminate debt. Within the confines of a balanced budget, treat consumer debt with extreme prejudice. What does that mean? It means after a minimal  emergency fund is established, the next priority is to eliminate the consumer debt (and a commitment to stay out of consumer debt).  How would I do it? I would list all my consumer debts (all but the mortgage for now) and rank them by the interest rate paid on each. Then I would pay the minimum amount on all debts except for the one that has the highest interest rate. That one I would pay as much as possible (while keeping a balanced budget). Personally, I would cut back on my lifestyle and use that saved money to make as big a payment as possible each month until it is eliminated, all the while staying within your budget. Here’s an example using the chart below:

This person has three debts, with amounts ranging from $1,000 to $5,000, and through squeezing his budget, can allocate $500/month towards paying down his debt. In the chart below you can also see interest rates and minimum payments. The first step it to prioritize the debt by interest rate. In this case, the first priority is the Visa card at 16%, then the MasterCard and last the Student Loan (See Priority Column). At this point, we pay the minimum payment to all debts except for the top priority. So we pay $125/month toward the MasterCard and $50/month toward the Student Loan. But the top priority, the Visa card, gets ALL of the remaining money available that month for debt reduction, the balance of the $500. In this case, that is $325 ($500 – $125 – $50 = $325). $325 is far more than the minimum payment requested, $60, so the pay off of this loan will be hastened. At this rate, the $1,000 Visa debt will be paid off in full in four months, at which time the payment amount of $325/month gets moved to the next highest priority, the MasterCard. That will make the MasterCard monthly payment $450, while keeping the Student Loan payment at $50/month. Once the MasterCard is paid off, about five months later, all the money will be put towards the Student Loan. In all, using this method called a Debt Avalanche, it will take 18 months to fully pay off all the consumer debt.

Debt Pay Off Plan Available to pay down debt: $500/month
Debt Name Amount Owed Interest Rate Minimum Payment Priority Suggested Payment
Visa Credit Card $1,000 16% $60 1 $325
Student Loan $5,000 6% $50 3 $50
MasterCard Credit Card $2,400 12% $125 2 $125

Step #3: Start serious saving! At this point, we have no consumer debt and $500/month which was used to pay off the debt available to save and invest. But invest in what? There is a priority in your savings and investment. If all you have is the initial emergency fund discussed in step #1, of $1,000, the top savings priority is to build up your emergency fund to self insure against disaster, which could return you to debt. How much is enough? The standard answer is somewhere between three and six months of household expenses, depending upon your risk tolerance. For instance, if your monthly household expenses total $5,000, then your emergency would need between $15,000 and $30,000.

Once your emergency fund is fully funded, it is time to start funding other priorities, starting with retirement. Why is retirement the second priority? Three reasons: first, a retirement account like a 401K, SEP or IRA requires a large amount of time to build up to meet your long term needs. Nothing like compound interest over time to build your nest egg. Second, a retirement account is tax preferred, meaning not only are you saving but you are paying less taxes all the while. Third, many retirement accounts offered by employers have a match program where the employer matches a portion of the savings you commit to your retirement account. In essence, this is free money given to you by your company which then will return interest in your account. How much is enough retirement savings? It is recommended that the full amount by law be saved and invested in a retirement account, roughly 15% of your net spendable income each month.

What’s next after the emergency fund is full and we are meeting our retirement savings needs? If you have children and plan to financially help them attend college, you need to set up and fund an education fund, like a 529 plan, and then contribute an amount that will meet your financial goals and timeframes. We are still not done saving yet. We need to save and invest for future needs too. Cars, homes, vacations and furniture are just some of the things we need to save for so that we don’t go back into debt when it is time to purchase them. In all, there are a lot of things to save for, but using a prioritized approach will ensure you don’t go (back) into debt when an emergency occurs or a large expense is required.

Some Sage Advice

Unknown-1

Warren Buffett is credited with some really sound advice on the topic of saving. To obtain and maintain financial freedom in our lives, he said we need to “spend what’s left after savings, not save what’s left after spending.” Here is where the balanced budget comes into play. It is crucial that we first factor savings into our budget to ensure our goals and dreams are being financed and to keep us from going into debt. Then, and only then, can we determine what we can afford in the way of monthly expenses. So often, people build up a lifestyle that is comfortable, only to find out they can not afford the savings needed to fulfill their dreams. They save money after they finish spending. Then find out there is not enough money left over to save! Make a budget, save first, then spend while not exceeding your income.

There you have it. The answer is quite straightforward, though it is not as easy as deciding between saving or paying down debt. The flow goes like this: Develop and maintain an emergency fund, then eliminate consumer debt, before saving and investing for your dreams and goals in life, including retirement, children’s education, homes, cars, vacations, etc. AND, all of this must fit into a balanced, sustainable budget in order to experience financial freedom. Financial freedom, it’s not easy, but it worth it!

Want more help with your personal finances? Start with Dave Ramsey’s Total Money Makeover. Click the image and SAVE!

The Total Money Makeover: Classic Edition: A Proven Plan for Financial Fitness