Kyson helps people make better personal finance decisions by challenging cliché advice and common misinformation.
Is Dave Ramsey Right About the Emergency Fund?
David Ramsey is a popular personal finance guru, who has written several successful books and has a radio show where he answers people's personal finance questions. He's best known for his "Baby Steps" method for helping people get out of debt and on their way to building wealth and having financial success.
In his books, one of the first Baby Steps is to set aside an emergency fund of $1,000 before putting all extra income toward paying off debt.
But is $1,000 enough money for an emergency fund?
The answer is, no!
For most people, $1,000 is not enough money to cover a major emergency. Below are a few reasons why this is not enough, and some tips about how to find the right emergency savings goal for you.
The 7 Baby Steps
Dave Ramsey's 7 Baby Steps are published on his website and are described in more detail in his first and most popular book, The Total Money Makeover. This is the book that most people should start with if you are interested in learning about Dave Ramsey's ideas. Even though I believe his emergency fund idea is flawed, many of the other steps can be helpful in your journey of financial growth.
The Baby Steps are a 7-part plan to lead you to paying off your debts and building wealth. The second step is the one that Dave seems most passionate about: Paying off debt! Dave Ramsey believes you should pay off all debt before saving more money or investing in the stock market. This is also debated by financial advisers and bloggers.
Whatever you think about the details of the 7 Baby Steps, it's no question that getting out of debt is an important step in gaining financial independence.
But one of the most controversial parts of the Baby Steps is Step 1: Building a $1,000 emergency fund. The purpose of this emergency fund is to be able to pay for something like a medical emergency or a car repair without going further into debt. After saving $1,000, you should put all extra income that you can toward paying off debt, according to Ramsey.
But lots of data suggests that $1,000 is not enough.
Read more about the baby steps
Emergencies Can Be Really Expensive!
An emergency fund is there to, at the very least, help you pay for something unusual beyond your day-to-day expenses: An unexpected car repair bill, or a medical expense.But is $1,000 enough to cover these sorts of emergencies? Not for most people.
A trip to the emergency room, depending on your insurance, can cost anywhere from $500-$3,000.
A car repair, especially in the case of a major accident, can easily cost more than $1,000, even if you have good car insurance.
Not to mention, these costs can vary a lot depending on where you live. According to AAA, the average hourly cost for labor on car repairs can vary depending on where you live in the United States: Hourly labor costs can be anywhere between $40 and $200!
What if you have an emergency room bill and a car repair bill from an accident? You could need to pay several thousand dollars! A $1,000 emergency fund won't be enough.
What could an emergency cost you?
Is Unemployment an Emergency?
What if you lose your job? Do you need an emergency fund to help you through a time of unemployment?
According to the Baby Steps, people should wait until after they have paid off their debts to save more to help them in case of unemployment. After paying debt, Step 3 is building up an emergency fund that could last you 3-6 months in case of unemployment?
But what happens if you lose your job before you finish paying off debt? Paying off debt can take several years to do, are you sure that your job is secure for 1-10 years?
If you lose your job, will you be able to pay your rent or mortgage for very long with $1,000? Probably not! Even in some of the cheapest parts of the country this won't get you very far.
Think about it: Say you spend a year paying off debt, and don't save up a larger emergency fund. Your rent for you and your spouse is $500/month. If you lose your job at the end of the year, you will only be able to pay your rent for two months! Not to mention other expenses like food. Of course, there might be some other help you can receive--unemployment checks, a minimum-wage job, but this still probably won't be enough if you are unemployed for more than a month or two. You might have some room on your credit card to use as a last resort, but you will only be able to buy groceries and supplies, you usually can't use a credit card to pay rent.
[FYI: On average, people are unemployed for 4-5 months at a time]
How much should you save instead?
Obviously, you want to pay off your debts, but it's really important to have a sufficient emergency fund first, so that you can survive in case of something like a car accident or unemployment.
So, if $1,000 is not enough--how much should you save instead?
The right number will depend on a number of factors: What are your expenses? What backup measures could you take if you have a big emergency (move in with family?)? What are you comfortable with? But here are a few tips to get you there:
- Read the details of your car, medical, house, or other insurance policies so you know how much you might have to pay in an emergency.
- Personally, I recommend people have at a pretty significant emergency fund before seriously tackling debt. Maybe start by aiming to 2 or 3 months of living expenses, and then add to it a little bit at a time while also tackling debt.
- To get that number, look at your budget and add up all the things you absolutely have to keep paying if you are unemployed: Food, rent, transportation to look for work, minimum payments on debts. Multiply that number by 2 or 3 (months): That's your goal.
- Until you have your emergency fund established, pay the bare minimums on your debts and cut your expenses as much as possible, and save that cash into a savings account you can easily access in an emergency.
- After you reach your savings goal, put 80-90% of your extra income into paying off debt but still keep putting 10-20% more toward your emergency fund: You don't know what the future might bring, so your emergency needs might go up in the future. You should start preparing for the future before it comes!
With a sufficient emergency fund, you can now safely move on to paying off debts and building wealth!