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Baby Step Three: How much should I put in my emergency fund?

Baby Step Three

Currently we are in step three of Dave Ramsey’s Baby Steps.  In step three you build up your emergency fund from $1,000 into a full “3 to 6 months of expenses in savings”.  This blog post goes into detail on how we chose to build our emergency fund.

1 month of Expenses

In order to get started with baby step three, the first thing you have to do is figure out how much money is one month of expenses for your family.  If you already have a budget, then this is easy.  I am going to log into EveryDollar right now and take a look.  Here is the breakdown:

    Fast offering 30
    Mortgage 1550
    HOA 140
    Water 113
    Natural gas 22
    Electricity 200
    Mobile phones 70
    Video streaming 22
    Internet 50
    Gas 80
    Groceries 800
    Shopping 150
TOTAL $3,227

In going through the budget, you can see that I did not include everything that could be considered an expense.  For example, I did not include taxes.  One expense that I struggled with a little bit, was should I include tithing in the above list of expenses?  After thinking on it, I decided that the main purpose of the emergency fund is to replace my income if I were to lose my job for whatever reason.  In that case, if I do not have an income, then I would not be paying tithing, so I have chosen not to include it.  Do whatever makes sense for your situation.

Three, Four, Five, or Six Months?

Why does Dave have say 3 “to” 6 months!?  Doesn’t Dave know that we are all mindless drones, and he should give us an exact number?  Well guess what, he does this on purpose.  Again, you have to decide what makes sense for your situation.

I feel as though my line of work (Software Engineering) is quite stable.  I have never gone a day without being employed.  However, in planning for the emergency fund, one thing to keep in mind is whether or not you are in a single income or a dual income household.  Since my wife is a stay at home mother, if I were to lose my job, we would have no other income to fall back on.  Similarly, my family is one of those families that is prone to medical issues.  With that in mind, for our situation, it makes sense to have a full six month emergency fund.

As you can see, the way to really decide if you need a three month fund, or a much larger fund is how much risk does your family carry?  You can think of the emergency fund as insurance against the storms of life.

Our goal

Now that we know that one month worth of expenses for our family is $3,227 and that we need six months of expenses, the rest is easy.  Our total emergency fund should be:

Full Emergency Fund = ($3,227 expenses / month) * (6 months) = $19,362

Dang gina.  That is a lot!  But, Math don’t lie.

How long will it take us to get there?

Currently, we have $3,271 in our emergency fund (~1 month worth of expenses).  We have a long way to go!  We are 17% of the way there and have $16,135 left to be fully funded.  In looking over the budget, I think we can realistically save about $3,400 per month, which puts us at:

Months to be Fully Funded = $16,135 / $3,400 = 5 months

Given that we have already budgeted out September, that means we will be building up the emergency fund for all of October, November, December, January, and February.  So, on February 1st, 2017 we will have a fully funded emergency fund!  It feels like that is forever away, but I am sure it will come before we know it.

Where to put the emergency fund?

It needs to be in a place that is easily accessible.  Dave suggests a money market account or a checking account that comes with a debit card or check-writing capabilities.  We happen to already have a USAA savings account that has both a debit card and checks.  Perfect!  The Annual Percentage Yield on this type of savings account is 0.15%.  Low, right!?  But remember this is not an “investment” account in the traditional sense.  This is insurance.

What counts as an emergency?

Lastly, how do you know if you should spend the money in your emergency account.   Dave suggests asking yourself three questions: Is it unexpected, Is it necessary, Is it urgent?   The more of these that you answer yes to, the more likely it is an emergency.

In Summary

We are glad to be building up a fully funded emergency fund at this time in our lives.  We can build it up faster now that we do not have any student loan debt.  I sm sure it will bring even more peace into our lives.  I just wish we could get through this step faster so that we could be putting more into retirement!  Maybe I will try to earn some side money somehow by getting back into mobile app development.  If you have an idea let me know!  😀

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What is Your Net Worth?

What is the single most important financial number for your personal finances?

I would argue that the most important personal financial number is: the amount of money you need to retire.  In Chris Hogan’s “Retire Inspired” book, he calls this your Retire Inspired Quotient (R:IQ).  What is that?  You could phrase this as “How much money do I need to retire?”  But that is not correct either.  If your assets are diversified across real estate, precious metals, stocks, etc., then it really is not how much “money” you have, it is how much your assets are worth.  However, this still is not correct either, because if you have a huge amount of loans that offset all of your assets negatively, then you really are not ready to retire.  Really what we are talking about is: How much money would be in your bank account if you were to die today and all of your assets were sold, and all of your loans were paid off from the proceeds.  The financial term for this is net worth.

Okay, so really what we are saying here, is that the single most important financial number is: The net worth I need to reach in order to retire. This means that the second most important financial number is your current net worth.  If you know both of these numbers, then you now know how close you are to retirement as a percentage.  For example, currently, I know that I am 7% of the way toward retirement.  The reason I know this is due to these two numbers:

R:IQ: $3,500,000
Net Worth: $242,299

If I just divide these two numbers (242,299 / 3,500,000 * 100 = 6.9%) we quickly arrive at the 7%.  At first, this may be discouraging.  But, what I have found, is that once you start tracking your net worth over time, it can actually be quite encouraging as you see your assets increase in value, and your liabilities decreasing, causing your net worth to quickly explode (in a good way).

How do you calculate these two very important financial numbers?  How can I calculate my R:IQ?  You can calculate your R:IQ using Chris Hogan’s website.  But honestly, that site just tells you the final number.  It doesn’t show you any pretty graphs or anything.  But it is good if you just want something to start with.  Another good site is bankrate.com.  Thebankrate.com calculator will actually show you a graph like the one below.  I like that bankrate uses a more conservative 7% rate of return rather than the aggressive 12% rate of return that Chris Hogan’s site uses.  The graph below shows your money building up as you save for retirement, and then finally the decline as you take money out of retirement.  This can also help you to know if you are on track throughout your income earning years.

How can I calculate my net worth?  Your net worth is defined as the sum of all of your assets minus the sum of all of your liabilities:

Net Worth = Assets – Liabilities

Simple right?  It really is that simple.  But what is an asset?  An asset is anything that you personally own which someone would pay you for.  Common assets are: 401k’s, IRAs, savings accounts, cars, houses, etc.  Similarly, financial liabilities are generally money that you owe to other people.  Common liabilities are: mortgages, student loans, car loans, money borrowed from family members, etc.  Let’s look at an example over the last 2 months:

8/1/2016 9/1/2016
Assets
Primary home $430,718.00 $430,101.00
Investment properties $158,992.00 $161,812.00
Retirement accounts $47,139.47 $51,747.15
Savings accounts $2,005.03 $4,275.31
Cars $10,721.00 $10,622.00
Total Assets $649,575.50 $658,557.46
Retirement Assets $218,857.50 $228,456.46
Liabilities
Primary mortgage $265,372.53 $264,852.73
Investment mortgages $151,662.18 $151,405.19
Student loan $0.00 $0.00
Car loans $0.00 $0.00
Total Liabilities $417,034.71 $416,257.92
Retirement Liabilities $151,662.18 $151,405.19
Net Worth $232,540.79 $242,299.54
Retirement Net Worth $67,195.32 $77,051.27

In the above example, you can see that I created two overall categories, “Net Worth” and “Retirement Net Worth”.  The reason I did this, is that there are some assets which you would not sell when you retire, so you can’t count them toward your retirement savings.  For example, I excluded our primary home from the list of Retirement Assets, since I do not plan on selling my primary home when I retire.

What tools can I use to calculate net worth?  As you can see above, I just use Excel (Google Drive).  Some websites, such as mint.com will do this for you, but do not seem to work that well.  Maybe at some point I’ll create a web site which does this in a clean way.

Net worth can be a useful tool in helping you to make financial decisions.  For example, when you use cash to buy a car, what would be the impact on your net worth?  The day you buy the car, for example, you could take $21,000 out of your savings account and walk home with a brand new car worth $21,000.  At the instant you bought the car, your net worth didn’t really change.  You lowered your savings account asset by 21k, but you added a new asset worth 21k.  However, after 6 months or so, that car has probably depreciated at least a thousand dollars in value.  So, your net worth has likewise gone down by a thousand dollars, which hopefully you are making up for in other areas.

Lastly, you’ll notice that I posted a lot of information in this post about my personal finances.  For whatever reason, details about personal finances are a taboo subject in America.  As Americans, we are very quick to show off our nice cars and homes.  But we are very private about all the debt we incur to get there.  Personally, I think it can be helpful to learn how others are winning with money and what has worked for them.  Everyone is in different financial stages of life, but I think we all have something to learn from each other.  Please share your insights and things you have learned along the way in the comments below!

If you are not already tracking your net worth, then start now!  It is hard to do retroactively, but easy to do in the present.  Good luck!