Life After Debt: Emergency Fund

As a follow up to last month's post Life After Debt: Roth IRA, I've decided to discuss my next major goal. My goal will be to build a $13,000 emergency fund in 2009.

Minimum Monthly Expenses
How do you determine monthly expenses? I decided to look at the bare minimums living expenses in my budget: rent, utilities, phone, minimal gas and food, minimum payments on student loans.

Assuming that I have paid off credit card debt by the end of the year, my monthly living expenses could be reduced to less than $1400/month in an emergency ($1200 once I've paid off my hospital bills). That $13,000 should be enough to allow me to live comfortably off of my second job for more than a year if an emergency situation arises such as job loss, grad school, career change, or I decide to travel around with my nomadic friends for a while. It will also be enough to help cover one time expenses such as car repairs, medical expenses, or emergency travel. You never know. I like to have options. I also want to have freedom and security.

Emergency Fund SMART Goal
By 2009 my emergency should be around $1000. I currently save $200/month, but some of that may go to the IRA. Assuming I have at least $1000 saved, I'll need to save an average of $1000/month to reach my $13,000 goal by 2010. So folks, that means my $1400/month debt reduction funds this year, will become Roth IRA + Emergency Fund contributions next year, plus the $200 I save now which could create a fund for larger items and vacations. I should have my hospital bills paid off by May 2009 so that will free up some extra cash as well.

Wow! Who knew I could go from drowning in debt to safe and secure with money to spare in only a couple of years? I didn't think it was possible, but I grow more confident every day.

Laddering the Emergency Fund
Once I have a $13,000 emergency fund, I'll be leaning towards a ladder certificates of deposit to maximize the ROI and minimize risk while still ensuring monthly access to funds. Jim from Blueprint for Financial Prosperity outlined a strategy to build such a ladder in a recent post.

Month 1: If you look at the ING Direct CDs, you’ll see that they offer 6 month, 9 month, and 12 month CDs (the rates are unimportant). Right now you need to find a CD that matures in 1 month, 2 months, 3 months, etc, but that will be impossible. The solution then is to buy one six month CD, one 9 month CD, and one 12 month CD. This sets you up to have three of your twelve months covered.

Month 2: Next month, you purchase another 6, 9, and 12 month CD. This sets you up to have half of the twelve months covered since the first set of 6-9-12 have now become 5-8-11. This puts your six CDs maturing in 5-6-8-9-11-12 months and your on-hand cash at seven months worth.

Month 3: You starting to see the pattern? Buying another 6-9-12 puts your total collection of 9 CDs at maturity dates of 4-5-6-7-8-9-10-11-12. At this point you also still have four months in cash sitting in your account.

Month 4: Now the pattern changes, since your CDs have now matured an additional year, you are looking at maturity rates of 3-4-5-6-7-8-9-10-11 months, but you can’t buy a CD of less than 3 months so you can only add an additional 12 month CD. This leaves you with three months of cash on hand and CDs maturing in 3-12 months.

Month 5: Add another 12 month CD to bring your full collection to 2-3-4-5-6-7-8-9-10-11-12, leaving you with 2 months of cash on hand.

Month 6: Add another 12 month CD and now you have a fully laddered 12 month CD structure in place, with 1-2-3-4-5-6-7-8-9-10-11-12 month maturity CDs! You still have one month of cash on hand.

Month 7: The first of your CDs has now matured and you’ll roll that into a new 12 month CD so that you have the full collection and still have a month’s worth of expenses in cash on hand. You will repeat this over and over and over …

Setting this up obviously takes a little time and effort. However, once you set it up you can basically go on autopilot. Most CDs (including ING) automatically roll over for the same term. That means, once you get all of your CDs to the 12 month term you can just let them ride.

Keeping Up with Inflation
Letting the interest accumulate and roll over on top of the initial deposit will (hopefully) keep your funds on pace with or ahead of inflation. Thats a big assumption, but I'll stick with it for now. I'm hoping that by the time I'm ready to implement this plan (circa 2010) the rates on CDs will be ahead of inflation. If not, I have plenty of time to re-evaluate the plan.

Savings After Emergency Fund
While I'm building this ladder, I will be able to start making extra payments to student loans and diversifying additional savings for better returns. I'll probably invest in moderate to aggressive risk investments such as stocks, bonds, and peer-to-peer lending. I'll aim earn a higher ROI on these investments than I'm paying on my student loans. Plus I'll be able to save up for unexpected investment opportunities. You never know what opportunity might come your way, but before I take big risks I'd like to know that I have a backup plan!

Thanks Lazy Man for including this post in the Carnival of Personal Finance!