Hi guys, Phil McGilvray here from Grandma’s Jars. Thanks so much for joining us. Today we are looking at tutorial four of our ten part series, our Top Ten Tips for Paying off Debt. In tutorial four today, we are looking at the importance of having a cash reserve in place before we start paying off our debt.
Identifying True Savings
In yesterday’s session, we looked at the importance of having a budget. And with that budget, the power behind that is that it helps us identify true savings. So once we have been through all of our expenses, we can then sit down and identify how much have we really got spare at the end of the month once all our expenses are covered. Now, the temptation is that once we identify that spare money, that true savings, is to start throwing it at our debt, at our credit card, and so on. And yes we do want to get rid of it – but the problem is, too often we will see people who go through that. They will throw their money, all their extra money, at paying off their debt only to find that something unexpected comes up. Their only option, having paid all their money off their debt, is to put that unexpected expense back on the credit card or to redraw the line of credit or whatever it might be, because they have left themselves too short of cash.
Rainy Day Fund
So before we get into throwing money off our debt, we need to build ourselves a rainy day fund. Now I have put here two reasons why we really need a rainy day fund. The first one is that we can’t budget for everything. It’s impossible to anticipate everything that’s going to come up. Yes, we can budget for 95% of expenses, but there’s always going to be that 5% of expenses we just can’t cover.
I’ve got a client for instance that just found out she’s pregnant. [It was] completely unexpected, completely out of the blue. [However,] there’s a whole lot of expenses that go towards covering the costs of a baby. Whether that is the medical costs or the new pram or the change table – whatever it might be, there are costs that are unexpected.
We recently found out that our two boy rabbits are actually a boy and a girl rabbit. Needless to say, we ended up with lots of new rabbits. Subsequent action from that was that they both got de-sexed, which costs a whole lot more than we had expected. So things come up that we can’t expect, that we can’t budget for. So what we want to do is budget for the 95% of things we can expect, but then for the 5% we can’t, you need to have a rainy day fund.
The other thing is, and it ties in with that first point, is Murphy’s Law. When we least expect things to come up, when we’re least prepared – things come up. It just seems for us, from our experience, is that things happen to people who are least prepared to deal with them. I don’t know why that is but it just happens. Interestingly, when people have the cash reserve in place, they have a budget in place. It seems that Murphy goes knocking on the next doors neighbour’s instead of yours, and these things just don’t seem to happen as regularly.
Murphy’s Law is real and alive and we see it everyday. Again, having a rainy day fund to cover those things so that you are prepared. But initially being prepared still means these things occur. Having a rainy day fund is really important.
Starting Your Rainy Day Fund: How Much You Need
Now the second thing that people ask me once we talk about rainy day funds is that, “Ok, you need a rainy day fund, how much is reasonable?” Based on our experience, two to three thousand dollars is what you should be aiming for. Two to three thousand dollars covers pretty much most expenses that come our way that we can’t expect – a major car big, if the fridge blows up, major medical expenses. Two to three thousand dollars will cover most of those. By having that reserve behind us we know that when those things come up we won’t be forced to put money on the credit card, rather we can get through those expenses with a cash reserve.
There’s nothing more demoralizing than paying a whole heap off of your credit card but then finding that because you paid off your credit card, you have no reserve behind you and that the big expenses needs to be put back on the credit card. You feel like you worked so hard only to have it all come undone again. Having a cash reserve will actually save us from that.
The Ideal Amount to Have in Your Rainy Day Fund
Now I have talked a bit about having a rainy day fund, a cash reserve. Typically your rainy day fund is just, in our first instance, two to three thousand dollars. However, what we want to build towards once we have our lifestyle debt paid off (lifestyle debt is things like your credit cards, personal loans, your interest free loans, car loans, so on) is to take the rainy day fund from two to three thousand dollars to an equivalent of 3 months worth of expenses. This is what we really want. In our previous tutorial we looked at the importance of having a budget. That budget helped us identify what we need to allocate per month to our future expenses. When we have a cash reserve, it’s these expenses we are trying to put aside. So having 3 months of these expenses worth in cash is what we aim for when building a cash reserve. But that’s down the track. We start with a rainy day fund and then we pay off our lifestyle debt, and once our lifestyle debt is paid off, we try to build our cash reserve to be 3 months worth of expenses.
Have a Rainy Day Fund Before Paying Off Debt
I hope that makes sense. I hope you understand why I’m suggesting we need this rainy day fund first. I often get a lot of resistance to this because people do just want to pay off their debt first and foremost. However, I have seen this come unstuck so many times that we now build into our process that before we tackle lifestyle debt, we need to have this rainy day fund in place.