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(In this – the third in a four-part series about the wise use of your Federal Income Tax Refund – we discuss the value of an emergency fund. With the exception of the first post, the advice in this series applies to any windfall – lottery winnings, gifts, even yard sale proceeds.)

Despite the guaranteed returns that come from paying off / paying down your debts, you may not be at that point yet. If you are drawing breath and have a pulse, you can be sure that tough times (a/k/a rainy days) are coming. An emergency fund can be an umbrella in a downpour. How much is that worth? It’s nearly priceless.

Recap

If you’re just joining us, we have been discussing what exactly your Federal Income Tax Refund is, and the things you can do with it other than buying a new TV. To recap, in the first post, we discussed that it’s called a Tax Refund because the government took too much money from you and you proved they had to give some back. Then, in the second post, we discussed how you can get a guaranteed return on your money over and above what banks are paying on savings accounts by using it to pay down your debts.   

Basic Emergency Fund

However nice a guaranteed return on your investment might be – and it is very nice – there is something much nicer.

An emergency fund.

What is an emergency fund? you may be asking.

An emergency fund is the barrier that stands between you and debt or maybe (eek!) more debt. To go with the analogy in the title, when you’re experiencing a [financial] rainy day, an emergency fund can be your umbrella. It can be the thing that protects you when everything seems to be going against you.

An emergency fund is a kind of self-insurance.

Let’s look at it this way: Tomorrow you’re on your way to work and you run over something in the road and shred two tires and bend the respective rims beyond repair – total damage $800. How are you going to pay to get your car back on the road so you can get to work? If your answer is “I’ll use my credit card.” You definitely need this article.  Actually, if your answer is anything other than “No sweat. I’ve got that much in the bank; I’ll just pay for it.” You need this article.

An emergency fund is that extra money in the bank that allows you to pay cash to cover emergencies instead of using your credit card. It is the buffer, the margin, between you and broke. If you have an emergency fund, you may be broke (i.e. out of money in your checking account) but you’re not poor (i.e. no money to your name). Broke is a temporary situation, so broke people make sacrifices. Poor is a mindset, so poor people do stupid stuff (like use credit cards).

I’m a huge Dave Ramsey fan, and I completely believe that before you go paying down or paying off your debts, you need to first establish an emergency fund. Check out Dave Ramsey’s Baby Steps for more detail on his plan. As for me, I’ll just say that if you’re used to being poor, you can’t even imagine how great it will feel when you get the comma for the first time.

What’s ‘the comma’? you may ask.

The Comma, is like magic. The comma is the difference between $999 and $1,000. See it there? The Comma means that you have FOUR figures in your savings account instead of just two or three.

I can still remember when Nicole and I saved our first $1,000. It was the greatest feeling in the world. I knew that I was finally an adult. I knew that we could finally make it on our own. Since that time, we’ve had our ups and downs – we even lost the comma a time or two. But, that was the moment we stopped being poor – we now had choices. We. Could. Do. This. No matter what “this” might be.

Having $1,000 in my name was a pivotal moment in my life. I can’t explain what happened our savings account went from $9XX to $1,000, but it was AMAZING!  My life changed. There was a psychological change – a permanent change that happened at that moment. And from that moment, regardless of how rainy the day became, my family and I have always had an umbrella.

You might wonder how I invested that $1,000 to earn the most on it. I didn’t invest it.

Yep. You heard that right. I did not invest my emergency fund; I left it in a standard (i.e. low interest-rate) savings account. Want to know why? I wanted to keep the money liquid. I wanted to make sure there was nothing that would stand between and emergency and my money. I had the discipline not to spend it (thanks to Nicole), but I wanted to be able to spend it if I needed to. I didn’t want to put it in a CD so that I would be tempted by the forfeit of interest, or in an investment account where the money was subject to swings in the market. Any of these things might discourage me from using my cash and encourage me to use a credit card to cover an emergency expense. I was devoted to getting out and staying out of debt, and I wasn’t going back.

Emergency Fund 2.0

So, am I advocating that you only keep $1,000 in your savings account forever? No. Way. You’ve got to have a little something (i.e. $1,000) set aside just in case – because there are going to be those cases. That little something will keep you from breaking out the plastic when your dishwasher goes out or when you blow a tire on the Interstate, while you are working to pay off your debts.

Start by cutting up the credit cards. Then pay them off. Next, pay off the vehicles. Then the student loans. Last, pay off anything other than the house. After that, you’re ready for Emergency Fund 2.0. (Yes, I waaaaay over simplified that. I’ll cover the process in more detail in another post.)

Let’s face it, $1,000 doesn’t go far – especially when things really get tough.

Ultimately, you need more than a grand in the bank. An adequate-sized emergency fund will be sufficient to cover your family’s living expenses for between three and six months. You be the judge on whether you define living expenses as just the bare minimum or something more extravagant. I’ll suggest that if you ever have to use it, you’ll probably sleep better at night if you have more than the minimum to get you by.

The purpose of this fund is to provide a backstop if disaster strikes. For example, if you lose your job, you’ll need this to keep the bills paid while you look for a new job or start your own gig. This might cause some additional expenses – more gas to get to job interviews, airfare, hotels, meals and entertainment expenses for networking, additional childcare, the list goes on.

This is your safety net. Don’t skimp.

Summary

You’ve heard the saying, “When it rains it pours.” In a downpour, an umbrella is invaluable. Everyone needs an emergency fund when one of life’s storms pops up. Start with $1,000 until you get your debts paid off, then build your fund to cover you in a much larger storm.

So, what do you do if you have your emergency fund and no debt? You stay tuned to the last post in this series: The Pinnacle – Financial Freedom

Check out our next post. Or, sign up for our newsletter and download the entire series with exclusive bonus content in our FREE book What to do With a Windfall (click here). 

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Part 1: It’s Called a Tax REFUND For a Reason

Part 2: Get A Guaranteed Return

Part 4: The Pinnacle: Financial Freedom