The Zero Dollar Emergency Fund …

If you own a boat that’s large, expensive, and is likely to take on water from time to time, you plan well ahead and put in a bilge pump.

But, if you have a dinghy and you’re paddling out on Lake Michigan, far away enough from shore to make swimming a poor second choice, then you carry a bucket … and, if the boat springs a leak (highly unlikely … it’s not a bad dinghy) or, water happens to come over the side from time to time …

… well, you start bailing water!

An Emergency Fund’s a little like that:

What you do depends on whether you expect the emergency [AJC: I know, it's an oxymoron] or not. Of course, if you expect it – or, can reasonably foresee it (like problems with a beaten up old car), then it’s not an emergency at all … just something that you can’t budget an exact amount for.

But, you can provision for it; at least, as best you can.

But, true emergencies do arise – or, semi-expected events blow up bigger and/or sooner than you ‘expected’ – so what do you do?

Try and build up and emergency fund but not spend it even if a really great investing opportunity comes up [AJC: what's the opportunity/cost of that?!]?

Or, why don’t you simply find a bucket of money that you can tap into IF an emergency arises … but, one that costs you zip (or, even makes you money) in the LIKELY event that an emergency does NOT arise.

Here are some examples of In-Case-Of-An-Emergency-Please-Break-The-Glass Funds:

1. A HELOC (home equity Line of Credit) that you put in place on your home ‘just in case’

Use an online mortgage calculator to make sure that you can borrow enough to cover your likely living costs + the repayments for as long as you think it will take you to get back on your feet and repay the loan. This is a pretty good, flexible option that only costs what you use.

The other advantage is that you should be able to raise a LOT more than you can save … and, it will be available as soon as you put the paperwork in place (a true emergency fund could take YEARS to save).

On the other hand – say, if you lose your job and the bank finds out – the HELOC may be revoked just when you need it the most … of course, if you’ve already drawn down the funds before the ‘pink slip’ is in your hands ….

2. Your 401k

There are usually provisions that allow you to borrow or withdraw funds against your Retirement Account; again, this may allow for ‘protection’ against fairly large emergencies (say, a few months off work), but it may come at a hefty opportunity cost … particularly, if the fund rules don’t allow for the funds to go back in on a tax-preferred basis, if you’ve managed to recover quickly enough.

Also, the tax and/or penalty interest costs may be quite high.

3. Your Car

Maybe you can do a sale and lease-back on your car .. or, maybe you can sell your car for cash and either use some of the proceeds to ‘trade down’ (therefore, freeing up some cash) or even make an exception to the “don’t finance a depreciating asset rule” by financing a (cheaper) one, instead (thereby, freeing up a lot more cash).

Remember, you’re really borrowing some money to tide you over in an emergency … you don’t expect to get out of it squeaky clean.

4. Credit Cards

Yep … this is the time that a bunch of credit cards sitting in a drawer can be really useful … but, it’s very expensive (19%+ p.a.) so make sure you only take this route for really short-term emergencies that you KNOW you can trade your way out of really quickly (i.e. less than a year).

5. The Three F’s

And … don’t forget that getting on your hands and knees and grovelling to your Friends, Family, or other associated Fools is also an option!

Anybody have any other true ‘Emergency Fund’ source ideas?

The Murphy’s Law Fund

Scott who – in my post proposing a Zero Dollar Emergency Fund – says:

I’ve given this topic a lot of thought and how do you feel about seeing a typical ‘emergency fund’ as more of a temporary ‘war chest’? In that, you are building up this cash savings reserve as fast as you can, while you scout for that next great investment opportunity (ie; stock in that excellent undervalued company that you researched, or that terrific foreclosure that you’ve scouted out in a great area that you want to purchase and turn into a rental property, or an excellent business idea or perhaps funding the expansion of your current business).

I figure that way, this money has a specific target(high returns that are more likely to get you to your number by your date) BUT, in the meantime, if Murphy pays you a visit while you’re building up this ‘war chest’, you have some liquidity(ie; emergency funding) to tackle that emergency. But, as soon as you have enough built up to take that next investment opportunity, take it with this money!

The short answer is that Scott has some cash lying around, and hasn’t yet figured out what to do with it. An ‘emergency’ pops up, so the logical thing to do is to dip into that cash and use it to solve the problem.

I don’t have any issue with that: but it isn’t an Emergency Fund. It also isn’t a ‘war chest’. It’s just some spare cash lying around …

Of course, I’m overstating things for dramatic effect, here

So, let’s take a look at the following graph to see what may be happening [AJC: I've adapted this graph from something to do with the 'mating cycle of dogs' that I found on Google image search, but I think it suits our non-canine purposes just fine!]:

Let’s pretend for a minute that this graph represents the amount of ‘spare cash’ that Scott has lying around (Y-Axis) at any point in time (X-Axis):

Scott starts building up his savings, has a little glitch as he realizes that he forgot to pay his car insurance premium by installments so he has to pay it all at once, then steadily builds up again until it reaches Scott’s ‘peak’  – his ideal Emergency Fund of $10,000.

Then Scott hits paydirt: an idea for a new online business, and he starts to spend that $10k on programming, domain name registration, hosting, Google Adwords and all the other stuff needed to get the ‘side business’ off and running. A couple of months and $9k later, Scott’s business is paying it’s own way [AJC: well done, Scott!].

Great, now Scott can start building that Emergency Fund again …

Do you see the problem?

The only time the Emergency Fund is adequate is between the time that Scott has managed to save up the full $10,000 and the time he starts spending the money on something else (in this case, his new business idea; it could easily have been a vacation, new car, girlfriend, or …?).

[Sigh] If only Life’s little ‘emergencies’ knew how to fit into Scott’s calendar [double sigh]

I guess it’s up to me to propose a better solution …

Next time

An inch is not a mile …

You decide that you need a new TV because your old one blew a tube (do they still have those?) and watching the blank screen is a real bummer.

You check your budget then the catalogs and decide that $900 is a reasonable target price for the type of TV that you want, so you trundle down to Best Buy [AJC: Ka-ching! That's another $1,250 for product placement. Whoohoo!].

Luckily they have the TV you want at only $850 … better yet, with your $50 Best Buy Rewards vouchers [AJC: + $350 Voucher Mention Bonus] you get the whole kit for $800.

So, what should you do with the $100 that you just saved?

That’s the question asked (and, comprehensively analyzed) in a guest post on I Will Teach You How To Be Rich on The Psychology of Money Savings, where the author talks about this as “the last mile of saving”:

So you’ve cut back your car insurance, negotiated a lower interest rate on your credit card—or nabbed a great deal on a new TV. You’re congratulating yourself for being a smart saver, and keeping more of your hard-earned money in your pocket.

Peter Tufano, professor of consumer finance at Harvard Business School, says that many people confuse a lowered rate (on car insurance), or getting a discount (25% off a TV) with saving money.

You can thank a psychological phenomenon that economists have dubbed malleable mental accounting.

C’mon, this isn’t a ‘mile’ … it’s barely a savings ‘inch’: you haven’t ‘saved’ anything … you’ve just spent 800 bucks.

Simple!

If you really want to think about saving, treat the $100 that you ‘saved’ from your original (actually, notional) $900 budget as ‘found money’ and save 50% of that.

Better yet, vacuum the dust off the back of your TV from time to time and maybe it won’t overheat and you’ll be able to ‘save’ the entire $900.

Got it?

The Zero Dollar Emergency Fund!

Last week I asked How many months do you have in your emergency fund?

Earlier, my blogging friend JD Roth at get Rich Slowly (GRS) asked the same question of his readers, and this is what he found:

This shows that more 7m7y readers have 3+ months living expenses in their ‘emergency funds’ than GRS readers, which means …

… I’ve done a terrible job

On the other hand, if you answered “what’s an emergency fund?” good for you, you’re already a step ahead of the pack … you see, not everybody – including me – thinks that you need to have an emergency fund at all!

[AJC: At least not until after you reach Your Number]

For instance, Liz Pulliam Weston writes at MSN Money that you should have a $0 emergency fund, replacing it with a concept that she calls ‘financial flexibility’:

The whole idea that everyone needs a big pile of cash, and needs it right now, should be rethought. In reality, the failure to have a fat emergency fund isn’t inevitably a crisis. At the same time, those who feel safe because they have three or even six months’ expenses saved up might be kidding themselves.

Let’s say your take-home pay is about $4,000 a month. Although you have been spending every dime, you make a concerted effort to trim your expenses by 10%. This not only frees up money for your emergency savings but lowers the total amount you need to save from $12,000 to $10,800.

Still, it will take you 27 months — more than two years — to scrape together your emergency fund. And that assumes nothing comes up that forces you to raid your cache.

Let’s explore this a litter further: JD Roth has $10,000 in his emergency fund, but that doesn’t just represent $10,000 today …

…. it represents the future value of $10,000:

Let’s say that you intend to retire in 20 years, if you earn 9% on your money (say, invested in Index Funds) then you are giving up, say, 2% bank interest (by having your emergency fund sit in an ordinary savings account for quick ‘emergency’ access) to earn 9% – or, a net of 7%.

That extra 7% earned represents about $8k in extra interest/profit that you are giving up for the benefit of ‘peace of mind’ in an emergency. But, we aren’t investing our money in Index Funds, because we are on a mission: we want to reach $7 Million in just 7 Years!

To us – that is, those of us on a steep financial trajectory - this $10k pile of cash represents seed capital for your new business venture or next real-estate acquisition [AJC: and, don't tell me that an extra $10k wouldn't be a big help for either of these endeavors] …

… now, $10k ‘invested’ at:

• 15% (stocks) grows to $35,000 after just 10 years
• 30% (real-estate) grows to $106,000 after just 10 years
• 50% (business) grows to $384,000 after just 10 years

… a slightly larger price to pay for peace of mind

I’ve received an award!

Online MBA

I’m not sure who Awarding the Web are, but they have kindly just listed $7million7years as one of their ‘Top 40″ Business Blogs in the “Saving Money” category.

This is kind of ironic as I am keeping company with the likes of Frugal For Life, Bargain Briana, Bitter Wallet, and FruGal [AJC: I love puns ... unfortunately for those around me, the more groan-inducing, the better] …

… but, this blog is about as un-saving money as you can get (!):

http://7million7years.com/2009/05/02/save-your-way-to-wealth/

Yet, we do spend a lot of time in Making Money 101 on saving tips:

The reason: habit.

While I stick to my guns and say that you can’t save your way to any reasonably large Number by any reasonably soon Date [AJC: Pick any Number north of $1 million, and any Date south of 15 years and see what you come up with, inflation adjusted], the reason why you should still save/save/save is twofold:

1. You create the seed capital that you might need for your first real-estate purchase and/or business venture … it’s these that will create your Number/Date, and

2. You create the habits that will stop you from spending your wealth once you get it.

Saving money is kind’a like the bookends to your financial life …

… but, true wealth building is in the bits you do in between that really have nothing at all to do with saving.

Well, not directly

What difference does 1/10th of 1% make?

Brian Tracey makes an interesting observation of making tiny, incremental changes which accumulate over time to make huge differences.

You could apply this principle to anything: for example, if you want to save 26% of your income (not a bad goal if you want to get rich slowly, with inflation chasing your tail), just start by saving 1/10th of 1% of your income today, and increase that amount by 1/1th of 1% each day until you reach your goal.

Use your ‘golden hour’ to read the personal finance headlines at http://personal-finance.alltop.com/ looking for money saving tips and you’ll find plenty of fuel for your daily 1/10th of 1% increased savings goal.

How much is in your emergency fund?

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I think this is a good time to take another look at your emergency fund; I’ll explain next week …

In the meantime, answer the survey to let us know how much you have saved specifically as an emergency fund, and leave a comment (if you like) to tell us why!

The problem with Henry …

Actually, it’s not the problem with Henry, it’s the problem with HENRY: High Earner Not Rich Yet.

Included in this group, a group that most workers mistakenly aspire to, are those doctors and ceo’s (at least those not in the Fortune 500) that I mentioned in yesterday’s post.

Now, this is only interesting because I can now answer the question posed on Twitter [AJC: you can glance across to the right to conveniently find a link to my Twitter account].

Dianne Kennedy (CPA), I think erroneously, links HENRY’s to taxes then lifestyle, but (as my article some time back about doctors also said), I think it boils down to three non-tax (even though taxes hurt!) issues:

1. As your income grows so does your spending … then some!

2. Keeping up with YOUR Jones (i.e. other high-flying corporate executives and professionals) is VERY expensive

3. You can’t sell a salary package (like I can sell a business, some shares, or a property or two) when you decide to retire

[AJC: You need both a big 401(k) - see reasons 1. and 2. why this doesn't happen - and a huge golden parachute, which may / may not happen to compensate for reason 3.]

If HENRY’s want to become rich, they have only two choices:

- Get lucky, or

- Invest a very large % of their annual earnings

Let’s assume that a HENRY – conveniently named Henry who happens to be ceo of a medium-sized business – is earning $290,000 and has already managed to save $1 million – our consummate Frugal Investor – and has arranged things so that he can continue to save a very hefty 35% of his salary (this is all pre-tax).

After 22 years, Henry will have saved just enough (in Rule of 20 terms) to replace his $290,000 ceo’s salary … by then, inflation adjusted to $661k per year, assuming that he wants to maintain his lifestyle [AJC: more importantly, assuming that he can - and wants to - 'ceo' for 22 more years ... if he 'only' starts with $500k in savings, he'll need to work for at least 26 more years].

Seems easy, but human nature [read: urge to spend it up] is what it is …

I should know: I was ceo of my own business, employing over a hundred people across 3 countries (USA, Australia, and New Zealand).

I paid myself $250k per year, and had cars, cell phones, laptops, and health insurance all paid for by my company – I reinvested all the remaining profits in these businesses.

I had a $1.65 million house in the ‘burbs, paid for by cash (s0, no mortage), and two children in school (one private, one public). We traveled domestically and/or internationally once or twice a year as a family, ate at ‘normal’ restaurants (and, the occasional top-tier eatery).

I can’t see how I could have saved 1/3 of my salary … I couldn’t even save 10%

Of course, I could have saved 10% if I really tried, but my point is that it’s very hard to save 30% of even a high salary, unless you gear yourself up to do it from the very beginning.

[AJC: Look, it's not my job to tell what should happen as you get richer, but the reality of what will happen and how to do better ... when you get to $250k you will bring with you exactly the same spending and saving habits as you have today, if not worse. Moral: start MM101 today!]

In other words, don’t divert all of your creative energy into playing Corporate Lotto (i.e. chasing a higher salary) if you want to get rich – or, even to reach a more humble goal, such as becoming debt free (a dumb goal, IMHO).

First – and, as soon as possible – learn how to get rich (or debt free, or …) by taking action right now, with whatever you can bring to the table.

If your salary happens to improve along the way, all the better … but, don’t rely on it!

The Myth Of Saving Your Way To Retirement …

Quite a while ago, I published a post that took a look at the supposed ‘power’ of saving …

… if you didn’t read it then, now would be a good time to ask yourself if you really care that weekly contributions of $34 could potentially grow to over $76,000 in 20 years, as proudly proclaimed by Fidelity?

One reader, Concojones, thinks that I have underestimated the ‘power of savings’:

Let’s not dismiss too quickly the good old save-your-way-to-retirement advice. Saving $15k/year for 40 years yields an expected $2.5M in today’s dollars (for what it’s worth: $10+M in retirement dollars), assuming your investments go up 5-6% per year after inflation.

Let’s not dismiss it too quickly, indeed. Retiring with $10 million in your pocket (albeit, ‘only’ worth $2.5 million in today’s purchasing power) is none too shabby.

The only problem that I can see – actually, the only FOUR problems that I can see are:

1. You have to be happy (well, ‘happy’ is a relative term) to work for 40 years,

2. You have to save $15k per year – easy at the end of 40 years, very hard at the beginning … and, even harder in the middle when you might be earning ‘only’ $50k (before tax) and have to put away 15% to 30% of your salary “with four hungry children and a crop in the field” [AJC: if you're old enough to remember that Kenny Rogers song]

3. You have to average 8% to 10% return on your type of investment – but it has to be one that lets you add $15k annual increments for 40 years (which ties you to ‘standard’ products like, CD’s, bonds, stocks, and mutual funds).

4. You MUST be disciplined enough to stick to this simple strategy for the entire 40 years WITHOUT WAVERING in up/down markets: the Dalbar Study [ http://www.canadiancapitalist.com/investors-behaving-badly/ ] says a firm NO to being able to achieve anything like this rate of return.

So, great on a spreadsheet, but I wouldn’t want to bet my life on it

Pay yourself first or last?

Adam (a staff writer at Get Rich Slowly) wants you to “challenge yourself” by replacing the the standard ‘pay yourself first’ advice with:

Only pay yourself first if you deserve it.

Now, Adam isn’t suggesting that you stop saving that 10% to 15% of your gross income that the bulk of the personal finance blogosphere recommends …

… what Adam is really asking is:

Should You Stop Funding Retirement to Focus on Debt?

[This] is one of the most heavily debated dilemmas in personal finance. Unlike “spend less than you earn” or “track every penny you spend”, there’s no cookie-cutter answer to this question. Variables such as age, career, risk tolerance, and even personality type make each individual situation unique.

This is a good line of questioning – and I encourage you to read his article – but, unlike Adam, I think there is a “cookie-cutter answer to this question”:

You should always ‘pay yourself first’ …

… but, where you place that money depends on where you earn the greatest after-tax return.

Keeping in mind that a “dollar saved is a dollar earned”, it could be in:

- Your 401k, potentially earning 8% plus the value of any employer matches (in an earlier post, we calculated this as providing another % point or two to your long term return),

- Your debts, potentially saving 10% to 30% interest on high-interest car, credit card, and consumer loans,

- Your real-estate investment strategy, potentially earning 15% to 25% in long-term rental increases and capital appreciation,

- Your seed capital for your new business, potentially earning 50%+ in future profits and windfall gains on the sale of the business,

- etc.

But, is unlikely to be found in paying off low interest student loans (saving 0% to 5%) or mortgages (saving 4% to 6%) or in investing in low interest savings such as bank accounts, bonds, or CD’s (earning 1% – 5%).

Blindly plonking your money into your 401k, or paying off debt, or paying down your mortgage is not the way to get rich(er) quick(er) … 7m7y readers always look at their options in terms of greatest contribution to reaching their Number.