Whew! This is the point where you are really getting a handle on this whole personal finance thing. You have paid off all debt except your house, so you should have some significant wiggle room between your income and your expenses. You are starting to see yourself as a winner in the money game, and it’s true! Now it’s time for the final step of your financial foundation: 3-6 months worth of expenses in a safe savings account.
Why do you need that much in savings?
Now that you have extra money every month, isn’t it enough to just avoid debt and pay cash for your splurges? Well, having 0 debt does put you miles ahead of the average American, you’re right. But you’re still a few hundred yards away from the short-term financial stability finish-line. So don’t stop running quite yet.
The next and final step for short-term stability is having 3-6 months of expenses in an easily accessible savings account. This is your emergency savings in case life suddenly gets a little too real. I hope that this step is a complete waste of your time. And for a lot of you, it will be. But the truth is that some of us will face an unexpected job loss, a short-term disability, a seriously ill child, or any of a hundred other things that can turn your life upside down. And for those, this will be one of the most important things you can do to make the hardest time of your life a tiny bit easier.
Three to six months’ savings won’t protect you from every tragedy that exists, but it will cover the vast majority of them. And even more important, if the tragedy is even worse, it will give you some time to get your sanity back after the initial shock. It gives you breathing space while you grieve. It allows you to concentrate on the people who need you, instead of “How on earth am I going to pay the bills next week?” Having that buffer savings is a favor that you will NEVER regret doing for yourself if the unthinkable happens.
How do I get my savings to that level?
This should be pretty easy. You have been paying off debt at a rapid rate by really throwing every extra penny at the debt you have. Well, now you can splurge a little to celebrate that accomplishment. (And by splurge, I mean a weekend get-away or a special but smallish new shiny thing – NOT a cruise around the world or a Ferrari!) And after the splurge, that extra money in your budget that you used to send to the credit card company or whatever creditor you were paying off should immediately head toward the nearest savings account. Just take the money that you were already putting toward debt repayment and send it to savings.
Where do I keep my savings?
The big thing here is that this is an EMERGENCY fund. In case of emergency, you don’t want to have to do something super complicated to get your money. So just put it in a money market account or a savings account. “But Jill,” you say, “This is gonna be a chunk of cash. Wouldn’t it be better to earn a little something on it?”
NO. No it wouldn’t.
And this is why. That’s not its purpose This is not money that is intended to earn interest. It’s money that is going to save your butt if something bad happens. You will invest in the next step. You will invest for the rest of your life. The money you invest will make you rich. But this emergency savings is not investment money. It’s “in case of emergency” money.
Don’t be penny wise and pound foolish with this money. Just put it somewhere safe!
What if I’m a spender and don’t trust myself to keep it?
Ahhh, great question. If you are afraid that you will lack discpline to keep that money sacrosanct for a true emergency, then put it at a separate bank from where you keep your checking account. Maybe a bank where you don’t have your electronic login info memorized, so it’s a hassle to use it for an impulse buy. You just want to be able to get to it without TOO much trouble if you you should really need it.
How much savings?
Three months’ expenses? Six months’? Or somewhere in between?
And the answer: it depends. This is based on several parts of your personal situation.
The first issue to get an actual number for your monthly expenses. How much do you realistically spend on non-negotiable in a month? Include housing, utilities, gas, car maintenance, food, and other essentials. However, you can probably skip any frills like lunches out. Just add up what it would cost you to stay afloat for one month, bare bones. Once you have that number, we’ll figure where in the 3-6 month range you should aim.
How much stability do you need?
When I was single and childless, I was a risk-taker. I figured the worst that would happen is that I would move back in with family for a few months. Now that I have a family and live in a different city, I need more stability. It would be a tremendous disruption to pull my kids out of school. That not only means we couldn’t relocate on a whim. It also means I wouldn’t want them to know that we were having financial trouble. My kids are worriers, and it would be important for them to see our lifestyle going on more or less as they were used to before. So stability is a huge need for us at this point in our lives. We wouldn’t even want to cut too far into the extras unless it got pretty bad. This points us to the upper end of the range.
Next question: How stable is your income?
If your income is strongly commission based, or your company has a history of layoffs, you will want to shoot for six months of savings, maybe even more if you have a family. On the other hand, my husband and I are both in incredibly stable jobs. I’m a teacher with great evaluations and many years experience in this district. My husband is a lawyer for the state in which we live. Plus, we could live on either one of our incomes if we absolutely had to. This points us to a lower savings amount.
Last (and most important) question: What is your comfort level?
Don’t discount your own emotions. If having six months’ worth of expenses in savings just makes you feel better, then by all means do it. If the other two questions indicate that you could go with less, and you don’t lie awake at night worrying about it, cut it down to three.
For us, even though our jobs are so stable and we have extra in the budget, I grew up on a farm in the 1980’s. And even though we made it through, losing the only home I had ever known was a very realistic fear for me. So we stick with the 6 months plan.
Ok, so now you’ve got the final step in your foundation. Next week: building on that foundation to create financial independence.