Monday, February 4, 2008

Money Monday - Budget, Part 3

As promised, today we will discuss (in more detail) the emergency fund and the debt snowball. If you are just joining in on this topic, you may want to skip back to the first and second parts of this series to catch yourself up.

Have you decided on how much you are going to have set aside in your emergency fund? As I mentioned last week, it all depends on your employment circumstances and your level of comfort.

Our family has chosen to keep an EF (emergency fund) of $1000 since my husband works 2 jobs and could conceivably pick up extra hours at either one if the other were to be suddenly terminated, which is unlikely in his field of work. Once our debt is paid off, we will "up" our EF to 6 months of living expenses.

Once you have determined how much you will be keeping in your EF, the next step is deciding where you will keep this money. The idea of an emergency fund is this: you may ONLY dip into the EF for a TRUE emergency. True emergencies would be unexpected car repairs on a necessary vehicle or your furnace going out in the middle of January - NOT a really good sale at the mall.

That being said, in case of an actual emergency, you need your money to be accessible. At the same time, you don't want it to be so accessible that you would constantly be justifying a reason to dip into it and providing yourself with that temptation. A separate savings account would be a good idea. A CD would not. You want to make sure that you will not be charged a fee for taking money out of your EF if you really need to. So keep it somewhere that fits that definition. Accessible, but not too accessible.

Throw every penny you have at your EF so you can have that in place while you are paying off debt. It is extremely important to establish the EF first because if you hit a financial bump in the midst of paying off your debt, you will have no choice but to put yourself into MORE debt in order to pay for your emergency. (And don't you DARE open a new line of credit!)

Once you have your emergency fund in place it is time to ATTACK your debt with a vengeance. If you do not feel hatred toward debt, you better work on it. Debt is a life-sucking, joy-stealing monster! Don't believe me? Get rid of it and see how much better your life is!

Now, for how to go about getting rid of your debt...
Our family is using a method called the "debt snowball" and it is the only method I can personally recommend. Do you remember when you were a kid and you used to roll snowballs all around the yard until you couldn't push it any farther? You started out with a tiny little ball and, as you rolled the snowball, it picked up more and more snow, faster and faster because it was gaining in size so quickly. The same theory applies to the debt snowball. Here is how it works:

List your debts from the smallest to the largest balance, excluding your mortgage. (We'll come back to the mortgage thing later). Please note: This is not the smallest payment nor is it the smallest interest rate. It is the smallest balance. What you're going to do is pay minimum payments on all of your debts AND at the same time, put every extra dollar you have into the smallest debt payment. When you have paid off the smallest debt, CLOSE THE ACCOUNT and add that payment amount to your next smallest debt. When that debt is paid off, do the same thing with the next one. See how your snowball is increasing in size?

For those of you who are visual learners like me, let me give an illustration:

Let's say you have the following list of debts:

1 Credit Card 1: $250 (min. payment: $10)
2 Credit Card 2: $700 (min. payment: $35)
3 Credit Card 3: $2300 (min. payment: $90)
4 Furniture Loan: $2450 (min. payment: $50)
5 Credit Card 4: $3100 (min. payment: $150)
6 Consumer Loan: $4600 (min. payment: $45)
7 2nd Mortgage/HELOC: $18000 (min. payment: $365)
8 Auto Loan: $23500 (min. payment: $450)
9 Student Loan: $26750 ($300)

And now let's assume that, after paying all of your minimum payments on all of your debts, you have $150 each month left over for your debt snowball. In less than 2 months, you would knock out the first debt. You would then have $160 to in your debt snowball. (Add your minimum payment from the first debt on your list and the debt snowball amount: $10 + $150 = $160). In about 3 more months, you would wipe out your 2nd debt. You would then add that minimum payment ($35) to your current debt snowball amount ($160) and put all of that money into debt #3. You get the idea.

You would continue this process until all of your debt (minus the mortgage) was completely gone! If, along the way, you encounter an emergency and have to dip into your EF, simply stop the snowball (but continue to make minimum payments) long enough to cover your emergency and then replenish your EF.

And THAT, ladies and gentlemen, is what we call the debt snowball.

But wait! I'm sure by now you're wondering: Why don't I pay off the highest interest rate first? Doesn't that make more sense for my pocketbook?

Well....sometimes, yes. But studies show that the motivation gained by seeing the momentum of your growing snowball gives you much more encouragement to keep paying off your debt than waiting 8 months to pay off your highest interest card first. Oftentimes, people who go that route end up losing their motivation quickly (because they do not see any quick results and therefore feel like their debt is not going anywhere) and giving up altogether. It may not make sense on paper, but trust me - once you get going, you will understand exactly what I'm talking about.

Now, about the mortgage....
The reason you do not include your mortgage in your list of debts is that most people's mortgage is a significantly greater amount of money than any other individual debt on their list. After you pay off all of your non-mortgage debt you will begin saving and investing and, since compound interest is a key component to saving, it's important to start saving before it's too late.

We will pick up with the mortgage further down the road in this series.

For this week, continue building your EF. If you already have your EF in place, then start listing your debts in order of smallest to largest and run some numbers on a debt calculator. You will be excited to see how quickly your smallest debts will disappear!

Coming next Monday: What do I do with my money when I'm debt-free (minus the mortgage)?

Links to the rest of this series:
Part 1
Part 2
Part 4
Part 5
Part 6
Part 7

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