Monday, December 20, 2010

Basic Principles or A Penny Saved

This is part three of my Basic Principles series. I recommend reading them in order.

Should I Carry a Debt?

Hows and Whys of Budgeting

This third part is useful to you after you've cleared the first hurdle of redefining debt in your mind and the second hurdle of coming to grips with your cash flow via a budget. I can't over emphasize the importance of both of these. Without them, this step, Saving, will do you little good.

Starting Off

In order to have something to save, you have to have worked out your budget to produce a small surplus. That means you are taking in more money than you are getting rid of through bills and other expenses. Check out the later half of the Hows and Whys of budgeting for some ways you can reduce your overhead to produce a surplus. My favorite is getting rid of status payments. What's that, you say?

I guess this should have been covered last time, but a Status Payment is the price you pay to have a new car vs. an old car, a smart phone vs. a basic cell phone or cable tv with the movie package vs. a DVD player and library card. If you are willing to part with your status payments, you can redirect that to SAVINGS!

There are many other ways to save money. If you own your own home, you have the option to make changes that can save you money on your heating and electric bills. We added a timer to our water heater and it's saving us about $40 a month. That, in turn, is going right into savings.

Be careful with home improvements. Some can cost big dollars and take forever to pay back if not never. We replaced our windows to the tune of about $8,000. There was a perceptible, but small, return on investment in the form of less need to run the AC in the summer and it's easier to keep the house warm in the winter. But it will take probably 12 years, or more, for the windows to pay for themselves. Plan carefully - look for low hanging fruit (like the timer for the water heater) if you are looking for low cost tweak with good returns.


So what's the big deal? Spend less and throw it in the bank for later - right? Sort of. Now that you have the ability to save, you have the ability to avert a lot of stress and crisis in the future. Dave Ramsey (and perhaps as a result many economists) advocates having your savings broken out in a couple of categories.

1. Emergency Fund. The emergency fund is just that - it's for emergencies. I like what Dave says here: "seeing a great pair of shoes you just have to buy is NOT an emergency." We have and have used our emergency fund. Usually this goes into car maintenance as that tends to crop up somewhat unpredictably. $500 to $1000 is a good amount. Since I have two cars I have to keep on the road, I went with $1000. Most non-catastrophic repairs are within that limit, and it happens to also be the sum of our insurance deductibles. So, in most cases, we are covered for car related emergencies.

The rule is: when you use it, pay it back FIRST, before any other savings or recreational spending. You want to have your emergency fund ALL THE TIME so you NEVER have to put something on a credit card. But aren't credit cards for emergencies? Yes - but only if you can and will pay it back before you start having to pay interest. That means you define emergency credit card use as "I am stranded and have no cash or ATM access". Otherwise, go get the cash and pay for the repair directly so you don't forget about the credit card payment (something I hope you someday are in danger of doing... it means you've stopped using your credit card for the most part!)

2. Living Expenses. Why would you want to SAVE for living expenses - isn't that what the budget is all about? Yes indeed - it is. But the key to a functioning budget is INCOME. Let's say you get laid off, or worse: fired. Unless you've been saving for this by establishing a living expense savings pool, you're in some dire straights and debt is just around the corner. Now - don't be fearful here. That's not the point. Unless you're totally without skills, you should be able to find something, anything, soon enough to get some small amount of income at the very least flowing again while you look for a better job.

There is also the possibility that you become injured on the job, in which case workman's compensation would kick in (but I will tell you from family experience - be prepared to fight for it). Then there's the possibility of just getting really sick for a long time and not being able to work. Disability isn't always such a sure thing and you are actively encouraged to become a sponge as everyone will be watching you to make sure you aren't out trying to work, hence demonstrating your lack of need for disability. This is really a whole other topic on which I have plenty to say having watched people suffer through it, but we'll save it for later. The point is - you will be glad you set up a living expense savings fund down the road.

How much is enough? How long did you spend looking for a job last time around? A week? (lucky you!) A month? Three months? A Year? If at all possible, you should have 3 to 6 months of savings. This is a long enough period of time to find a job, or rearrange your life if you have become disabled to reduce your expense or find a new career path that will allow you to be productive. If you have limited skills, you may want to consider saving for a longer time as your job options will be limited. This is always, by the way, a good reason to pursue continuing education while employed. You never know when you're going to need a fall-back plan.

I was without a paying contract for 5 weeks once upon a time. If I had not saved about 4 months of living expenses up to that point, we would have been in trouble. I aim for the 6 month level currently and am a little bit behind in that department. Why didn't I take unemployment? Because I didn't feel that I should. I was capable of working and was working to grow my own business at the time, so I just kept on truckin'. Taking unemployment would have meant playing by the rules someone else decided for me and ultimately, what better motivator is there to get out and find work than knowing your living on borrowed time?

3. Goals So what goals do you have now? Really, once you have saved for emergencies and contingencies, you are free to dream. My favorite thing to do at this point is pile into debt elimination, like the mortgage or whatever your biggest remaining debt is. Hopefully you're already working on that, but now that you have breathing room, free from worry of being caught short, pushing money into debt elimination is the next best thing to do. Some would say you should get rid of your debt before anything else (and I think that is very prudent), but an emergency fund is pretty critical to keeping you out of debt, and the living expenses are pretty key to keeping things running in times of economic uncertainty. But, if your debt is a huge problem and is bleeding you dry, you may want to put living expenses on hold and kill debt first.

We chose to eliminate debt while saving for living expenses. It was a tight time, budget-wise, but we blew away tens of thousands of debts in about 2 years by focusing on it using Dave Ramsey's "Snow-ball" plan. With that, you pay your smallest debt off first. Once it's gone, you add the payment you had been making on it to your next largest debts payment, accelerating it's pay-off rate. When that one falls, you roll up your payments to the next largest debt. Pretty soon you have a massive ball of cash roaring down the mountain wiping out debt like so many small trees!

Other goals, if your debt is liquidated, might be saving for college for your kids or yourself, or you might save for your dream home or retirement. The world is your oyster when you have moved yourself out of debt repayment and into cash accumulation. You might also want to invest, but that's an advanced topic we'll touch on in a future installment which I encourage you to be thinking about.

Looking Back

So, if you've made it this far and have implemented the suggestions I've made along the way and you have a budget that balances, debt on the way down the drain, and a growing savings account, you're well on your way to what Dave Ramsey calls Financial Freedom. I have oft quoted him here and all of the material that is in my head that was put there by him came from "Total Money Makeover" or his radio show which I used to be able to listen to. It's only a $10 book but you get the equivalent of a $300 seminar in terms of education. It's a life changer which should affirm and reinforce everything I've covered in the Basic Principles series. You would be well served to go get a copy. I in no way derive any income from promoting it - it's just the right thing for me to do.

I also encourage you to continue your education beyond this website. If you just happened to find it or were referred by a friend, there are tons of free resources out there to get you educated on all things fiscal, fiduciary and financial. And I hope you'll check back here for more in the future... or go learn something cool and contribute an article that would help others learn to be financially savvy and free.

Till later...

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