As part two in the debt/savings series we will focus on creating Savings Cushions. One of the most common questions regarding the debt/savings hurdle is how much to set aside and how much to pay toward debt. I often find that my clients are so frustrated with their debt that they throw all their extra cash toward it and then find that the next month they have to pull the credit cards back out to pay for living essentials or one of life's fun surprises because there is nothing left in savings.
You'll notice that we aren't even talking about retirement savings yet- and that is because if you are still in the phase of trying to dig out of credit card and student loan debt, then retirement saving isn't going to help you a whole lot. Why? Because when you are in the retirement age group, you don't want to be saddled with these payments on limited income. That's not to say that you shouldn't be saving up for retirement if you have student loans- you should!- it's just a matter of balancing.
I like to think of a room filled with big, bright cushions on the floor. Each of these cushions are designed to protect you if you fall when you are going about your activities in this room and serve a different kind of protection. In the last post, we talked about looking at your monthly spend. If you did that activity, you know about how much money you need to get by each month. For people who are self-employed, ensuring that you have that cash in the slow times is critical, as is having money for major emergencies like a house repair, car repair, etc.
The first cushion you should have in your room is the red one- this is the Emergency Cushion. The emergency cushion is for exactly that- an emergency. We are talking about the oh-shit variety like your plumbing just backed up or your car just shut down on the highway. Typically, you want at least $1000 in this fund. Once the fund gets drained, this is the first savings cushion to be replaced before any others, before you make an extra payment on a credit card, before you buy a steak dinner. So we keep this fund stocked as a separate savings account.
The next savings cushion is the Event Cushion- the one for the items you KNOW are coming up in the near future that aren't part of the monthly budget. For example, if you know you have a big beach weekend coming up or that your dog has an annual vet visit coming up or your kid's summer camp fee is due, then you create a special savings cushion for that event. You begin setting aside cash to fund that cushion- because if you don't that's just more debt headed your way. If you can plan it far enough out, the savings can be set aside each month to fund it until the event arrives. These funds might sit in your checking or your savings accounts, but should be kept aside for the event coming up.
Once these two cushions are set up and funded, we can start looking at paying a little extra on debt- and we will talk about structuring debt payments in the next blog post. However, there's still another savings cushion to prep before taking a real dive into debt repayment: the Cash Reserves Cushion.
This one is especially for the self-employed, but applies to employees as well. The Cash Reserves cushion is based on the idea of having "working capital reserves" for you/your business. How much does your business need to stay afloat for a month? For employees and self-employed alike, how much do you need to stay afloat? For small business owners in service based businesses, this answer is intertwined as business overhead may be low, but the owner is fully dependent on the income to pay personal bills- so the total per month is lumped together for cash reserves. For a larger company that has employees, it is a completely different scale as the business needs its reserves and the owner also has a whole other set of reserves needed for monthly spend. This is a big savings goal to work with and it is important because what happens if you are laid off or have a bad sales month or are sick? The Cash Reserves cushion is even more important at this point to fund than retirement savings because it can plop you right back into debt. Also, taking money out of your retirement fund to pay for these situations often involves an early withdrawal penalty and, in many instances, taxation, so we want to be sure there are savings set aside for these situations rather than reliance on credit lines and credit cards.
It seems like a lot, right? However, these are the goals we are working toward. If it feels discouraging, start working on numbers one and two first.
Next posting we will dig into debt payoff theories.
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