Time again to do the debt free dance! If you've followed the first four parts of the “How Do You Get Out of Debt?” series, you should now be mad, naked, doing a budget, have a small emergency fund, and working on a Debt Rocket plan.
You are putting a smackdown on debt and getting control of your money.
YOU ARE THE MAN!
Unless, of course, YOU ARE THE WOMAN!
Once you have implemented your customized Debt Rocket plan, it might take you a few months to a few years (depending on your situation) to pay off all of your debt except for the house.
As long as you stay intensely focused, you'll get it done. I have confidence in you!
But once you get your debts paid off, that doesn't mean you're done.
So What's the Next Step to Get Out of Debt?
At this point you have no debt (except maybe for a mortgage. I'll get to that later in the series), and you're no longer using any credit whatsoever. It feels great to finally have some breathing room financially, so your mind starts working overtime, thinking what you could do with all that extra money.
Whoa there buster, slow down!
Don't start thinking about Jimmy Choo's or custom fitted golf clubs just yet. Upping your lifestyle or buying a bunch of stuff is not where your head needs to be right now. You still have more work to do.
So now what do you do with all the money you've been sending in to pay off debt every month?
Build a Large Emergency Fund
Now it's time to add to your small emergency fund, and start building a much larger emergency fund that is equal to at least 3-6 months of your household expenses, kept in easily accessible cash investments such as a savings or money market account.
When I say 3-6 months of “expenses”, I mean things like food, housing, electricity, water, gas, transportation, etc. I don't mean 3-6 months of pay.
However, more is obviously better. Some experts even recommend 6 months to 1 year of expenses in cash.
Of course I'll reiterate what I said in the 3rd post in the series. This money should be used only for an emergency!
Emergency Fund Questions
As always, I'm sure you have some questions about this very important step in the journey to financial freedom, so let's address those now:
Why Do I Need a Large Emergency Fund?
You need it so you can stay afloat financially during a major crisis. Studies have shown that in any given 10 year period, 75% of families will experience a major financial crisis such as a hospital stay, job loss, natural disaster, fire, a car accident with injuries, temporary/permanent disability, etc.
When you plan well and have a large emergency fund in place, it ensures that any major emergency will have as little impact on your finances as possible. It helps to keep you from incurring new debt and having to deal with the financial fallout from that emergency for years to come, on top of what you already had to go through.
That's a Lot of Money, Shouldn't I Invest it and Let it Grow Instead of Letting it Sit in Cash?
No, because money that's invested in places like the stock market can be volatile and go down in value. Trust me, if you need it in an emergency, you can just about guarantee that you'll lose a big chunk of that money in the stock market right before you need it the most.
Keep your emergency fund money as cash in a savings or money market account so it doesn't lose significant value and is easily accessible. Do not put it in CD's (illiquid), Stocks or Mutual Funds (volatile and illiquid), and especially not Real Estate (very illiquid).
What Happens if I Need to Use Part of My Emergency Fund?
Use only enough to get you through the crisis. That big chunk of money can be tempting to use for “extras” that don't necessarily relate to whatever emergency you're having at the time, so manage it very wisely and conservatively as you use it. Don't let it leak away drop by drop.
Once the crisis has passed, work to replenish your emergency fund back to the proper level as soon as possible. This means that all money available over and above your normal living expenses should go to build it back up so you can be ready when the next emergency raises its ugly head.
An Emergency Fund is Self Insurance
When you have a large emergency fund in place and available to you in a time of crisis that is easily accessible and fully funded, it self insures you, and keeps you from being tempted to use debt to “fix” the situation.
If you don't take this very important step for ensuring that you never have to go into debt again, you'll be tempted to use credit cards and other debt when the inevitable emergency comes and you're desperate. The result is that you can end up paying for that emergency for months or even years to come, causing you to possibly even be in debt when the next crisis comes.
Lack of an emergency fund is just one of the many reasons why so many people have ended up with major financial problems over the last few years, as jobs were lost and wages have gone down. A well maintained large emergency fund is the insurance you need that will help keep you from sinking financially when a crisis eventually comes, as they always do.
Keep Up the Hard Work!
So continue working hard on your Debt Rocket plan, and when you finish, keep your dream of financial freedom alive by building up your large emergency fund. You won't regret it!
Questions: Have you ever used an emergency fund (instead of credit) to deal with a crisis? Have you ever used credit during a crisis and wish you had had an emergency fund in place?
Tell me about it in the comments.