Baby Step 1 - Starter Emergency Fund

In my last column I introduced Dave Ramsey's Seven Baby Steps (see http://www.daveramsey.com/new/baby-steps/). The baby steps are as follows: (1) save $1000 to start an emergency fund, (2) pay off all debt using the debt snowball (besides your home), (3) 3 to 6 months of expenses in savings, (4) invest 15% of household income into RRSPs, (5) college funding for children, (6) pay off home early, and (7) build wealth and give.

I promised I would embellish on these steps in future columns in answer to specific questions. This week I will address a reader's question about the first step: "Why should I save $1000 for an Emergency Fund before I pay off my debts? Couldn't that money be better used to pay down debt?"

There are several reasons for starting with this $1000 safety net, but I believe the most important reason is psychological. Remember in my first column when I mentioned that personal finance is 80% behavior and only 20% knowledge or math? Mathematically, you would probably save a little bit of interest by putting every dime toward debt. However, if we all analyzed our decisions mathematically, we wouldn't have financed that big-screen TV in the the first place!

It's the behavior, not the math, that matters. You will behave differently with a $1000 cushion that you would if you were just scraping by. With $1000 you are prepared to make a full commitment to get your finances in order. With $1000, you can seriously commit to never using debt again. There will be no more living paycheck to paycheck, spending every dime earned, and going into debt when cash runs short.

If you blow a tire with $1000 in the bank, you won't lose any traction (pardon the pun) as you pay cash for a new tire and build back to $1000 as quickly as possible. Going further into debt when you've made a commitment not to use debt is a psychological blow that could completely derail you, even if mathematically you might be paying slightly more interest. I know, $1000 won't cover a new transmission or furnace, but in most circumstances $1000 is enough to provide cushion against unexpected expenses but not so much that it is difficult to get started.

If you have any personal finance related questions, please email me!

Underlying Financial Principles

Thanks for your responses to my column two weeks ago. In that column I explained that the dreaded "B-word" (budget) must be the starting point for improving your life financially. If you don't have control over your money by knowing where it is coming from and where it is going, your money will have control over you!

Some of you asked for more information about the Seven Baby Steps I referred to in my last column. This week I'll answer the question, "How do I create a plan for getting out of debt and improving my family's financial situation?"

There are many ideas out there about how to put together a financial plan. The best program I have found is Dave Ramsey's Seven Baby Steps (see http://www.daveramsey.com/new/baby-steps/). The baby steps are as follows: (1) save $1000 to start an emergency fund, (2) pay off all debt using the debt snowball (besides your home), (3) 3 to 6 months of expenses in savings, (4) invest 15% of household income into RRSPs, (5) college funding for children, (6) pay off home early, and (7) build wealth and give.

I can discuss these steps further in future columns to answer your specific questions, but I'd like to point out some important principles underlying these steps: intensity, focus, and patience. It's hard to get traction when you try to do too many things at once. Unless you make an unusually high income, you're not going make any meaningful progress if you try to pay off debt, build an emergency fund, save for retirement, put money away for college, pay extra on your home, and make other investments all at the same time. Take one step at a time and put all your effort and extra money into that step. This is especially important for the first three steps. You can't succeed financially if you have debt payments eating up your income or no savings to keep you from going back into debt when emergencies happen.

Patience is important because there's no such thing as get rich quick. Doing well financially takes hard work, discipline, and time, but the resulting peace is well worth the effort. It's takes a typical family two to three years to get through steps one through three and then another seven years to pay off their house. Step seven is where it gets really fun - imagine having no debt, being on track with retirement savings, and having extra money to invest, spend, and give away. If you're a typical family, this will only take 10 years!

If you have questions about the baby steps or anything relating to personal finance, you can email me.