photo credit: hill.josh
Jim and Doris were highly motivated about getting out of debt. They listed all of their debts, worked out a budget and agreed that they could pay an extra $300 every month above the minimum payments. During the first month, their air conditioner compressor quit working. A month later, Jim’s fuel pump went out of his car. Then, during a driving rainstorm, their roof started leaking. Because Jim and Doris had depleted all available cash in their zeal to reduce debt, they were not prepared for life to happen. How did they pay for these emergencies? By using their credit cards.
“Jim,” Doris moaned, “we are worse off than before we started. I feel like giving up.”
The Need for Step One
When Dave Ramsey began counseling others, he was so driven to help them get rid of their debt that he challenged them to throw every penny toward debt reduction. The problem, he soon discovered, is that when the unexpected happens, there are no resources to deal with it and when people go deeper in debt to handle these emergencies, they start to lose hope. Dave Ramsey’s Baby Step One, therefore, is to save $1,000 before trying to pay off debt.
This $1,000 provides a small buffer between their plan and life. While saving this $1,000, people learn how to budget and live on less than they make. They are preparing for the time when they will have no debt and can save a sizable emergency fund (Step Three). I have witnessed scores of people, many which have never saved for anything in their lives, experience this victory of saving a target amount. Achieving this first step builds confidence and prepares for future victories.
With Jim and Doris, the emergency fund would have been there to help them with these unexpected expenses. Of course the $300 a month they had earmarked for debt reduction would need to be used to rebuild the emergency fund, but they would have the peace of mind in knowing they had planned and not been “forced” to use their plastic.
Where Should I Keep This Money?
Good question. It needs to be kept where it is accessible but not mingled with other funds. A simple idea is to open a Money Market account with check writing privileges, then don’t use that account for anything other than emergencies.
Should Everyone Always Use the $1,000 Amount?
No. The key is to understand the purpose of this fund and make it the appropriate amount for your situation. Here are some exceptions to the $1,000:
- Dave recommends that those with household incomes of $20,000 or less should try for $500. Why? Remembering the principles of behavioral finance, we don’t want them to get so discouraged by the process of saving the $1,000 that they give up before getting to Step Two.
- A possible emergency is pending. For example, if the wife is pregnant, the couple should make minimum payments on all debts and use the debt payment cash flow to build up their emergency fund just in case it is needed. If, after the baby is born, the extra money is not needed, use everything above the $1,000 to pay off debt at that time.
- Job situation is highly unstable. As in point 2, stop the debt snowball and use all extra cash to build as big an emergency fund as possible. Once the crisis passes, go back to paying off debt again.
Closing Thoughts on Step One
Get focused and get it done. The faster you complete Step One, the more momentum you will have built to carry you through the next steps. Have yard sales, work overtime and make sacrifices in your budget, such as no eating out or vacation. When your broke friends and relatives start thinking you are weird, you are on track.
Next post in this series is Baby Step Two: Debt Snowball