If you’re new to Dave Ramsey's Baby Steps, (or Chicken Steps as one of my clients calls them), Baby Step #3 is to fully fund your emergency fund. The first three baby steps are done one at a time, with intention and in order. The first Baby Step is to establish a baby emergency fund of $1,000. The second baby step is to pay off all non-mortgage debt. Yep, this includes paying off those pesky student loans and car loans! Baby Step #3 is to save 4-6 months of expenses.
As clients arrive at this step, questions start to arise about how much is enough for the emergency fund? Do I save 4-6 months of income or expenses? Where do I save this money? Shouldn’t it be earning interest? So, let’s dive in!
As mentioned above a fully funded emergency fund is the amount of money it will cost you to live for 4-6 months. For example, if have $4,000 in living expenses each month, you will need between $16,000-$24,000 set aside for emergencies.
The same energy that is used to pay off all of the non-mortgage debt can be used to fully fund this emergency fund. Why would you save that much? Well, do you remember your uncle Murphy? That relative that comes to visit unannounced. Murphy’s law says, "anything that can go wrong will go wrong." So, this fully funded emergency fund is a buffer between you and Murphy. Trust me, the likelihood that Murphy shows up when you have this fund is slim to none. In the rare occasion that Murphy does show up and a car is totaled or a hot water tank needs replaced, those events become inconveniences, instead of catastrophic occasions that require you to take out a payday loan.
There’s also a question about how much is enough. If you have between 4-6 months of expenses, you’re golden. If you want to know the exact dollar amount, have a conversation with your partner or a friend. What is most comfortable for you? Are you the only person in the household that bring in money? If so, maybe you would opt for an amount closer to the six-month worth of expenses. If there is more than one household income and not as many monthly expenses, maybe four months is enough for you. The number really doesn’t matter if you (& your partner) are on the same page about that amount serving you as an emergency fund. Oh yeah, and Christmas is not an emergency!
I’ve had people ask me if where they should keep their emergency fund. When you begin to have this amount of money in emergency funds, the tendency is to make even more money on your money. However, this is not an investment. It is a set amount of dollars that needs to be readily accessible in time of need. When you invest the money, you take a risk in losing some of its value and not being able to access it when you might urgently need to. Hello, new furnace! Kent and I keep our emergency fund in our savings account but that doesn’t work for everyone. It may need to be in an account at a different bank or credit union to reduce the tendency to spend the money. No, having our emergency fund in a savings account doesn’t earn us a ton of interest. And THAT IS OK. We know it’s there and we’re keeping Murphy away from our house, most of the time.
Now that you know how to fully fund your emergency fund, let’s get started. Make savings a line item in your monthly budget and get saving. This baby step typically takes clients 6-12 months to achieve, depending on their level of commitment to sticking to their budget and intentionality in saving.