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. Now we can talk about building a 3-6 month emergency fund.
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 for Getting 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 credit whatsoever. It feels great to finally have some financial breathing room, 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. Increasing 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 using to pay off debt every month?
Build a 3-6 Month Emergency Fund
Now it's time to add to your small emergency fund. You will start building a much larger emergency fund equal to at least 3-6 months of your household expenses. You should keep in easily accessible cash accounts 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.
3-6 Month 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 3-6 Month Emergency Fund?
You need emergency money so you can stay afloat financially during a major crisis. Studies have shown that in any given 10 year period, 75% of families 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 dealing with the financial fallout from an 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 invested in the stock market tend to 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 My Emergency Fund?
Use only enough to get you through the crisis. That big chunk of money sitting in the bank can be tempting to use for “extras” not related to the emergency you're having at the time. So manage it wisely and conservatively as you use it. Don't let it leak away drop by drop.
Once the crisis has passed, replenish your emergency fund as soon as possible. All money available over and above your normal living expenses should go to build it back up so you'll be ready when the next emergency raises its ugly head.
An Emergency Fund is Self Insurance
When you have a 3-6 month emergency fund available in a time of crisis that's easily accessible and fully funded, it self insures you. It keeps you from being tempted to use debt to fix the problem.
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 you can end up paying for an emergency for months or even years to come. When the next crisis comes, you may be still paying off debt from the last one. That's a recipe for disaster!
Lack of a long term emergency fund is just one of the many reasons why so many people end up with major financial problems. A well maintained 3-6 month 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. When you finish, keep your dream of financial freedom alive by building up your 3-6 month emergency fund. You won't regret it!
Questions: Have you ever used cash 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.