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!