· Save 3 months’ worth of expenses
· Contribute enough to receive your employer 401k match
· The importance of having a decent cash reserve before debt paydown
· How to build your cash reserve
In terms of personal finance advice, the most common advice you hear starting out is to clear your debt as fast as possible. This is good advice, but only in when certain things are in place. Clearing debt aggressively can be very dangerous because your lack of liquid cash puts you at risk to take on more debt (usually credit card debt).
What do you need to do before paying debt aggressively?
· Save 3 months’ worth of expenses in a separate checking account
· Contribute the exact percentage in your 401k to qualify for employer matching
Save 3 months’ worth of expenses
The reason why I recommend 3 months of expenses is because it shouldn’t take that long to build and is enough cash on hand to handle any sort of emergencies or unexpected expenses. Some financial experts like Dave Ramsey recommend building a smaller emergency fund because they want you to become more aggressive in your debt paydown.
This poses a lot of risk especially if you follow the Dave Ramsey $1000 baby emergency fund. $1000 is not enough of an emergency fund in today’s economy
. Imagine what would happen if your car needs repair and maintenance or if you must go to the hospital or receive any other type of medical treatment. I have seen people in my life follow this advice of having a small cash reserve while paying down debt and most of the time they had to use credit card debt when these unexpected expenses came up. Therefore, I say 3 months is enough for you to feel comfortable when deciding to start putting a lot of cash towards paying off debt.
To build this 3-month cash reserve, I recommend reducing your expenses as much as possible and then at minimum putting 20% of your paycheck towards that cash reserve. Within a few months that 3-month cash reserve should be fully funded.
Only use this 3-month cash reserve for emergencies and unexpected expenses. Look at the cash reserve as an insurance policy against you having to go into more debt while you embark on your journey of a debt free life.
It is also important that his cash reserve is put in a liquid checking account because you want to be able to draw upon this money at an instant. This reserve is not meant to be invested because it is an insurance policy against the unexpected emergencies life throws at you.
The accounts where you want your money to work hard and grow is in your 401ks, IRAs, and investment accounts which you will be growing aggressively once you are debt free.
Get your employer’s 401k Match
Some financial gurus (i.e. Dave Ramsey) recommend that you do not invest period when you are trying to pay down debt. I agree to a certain extent, but if your employer matches your 401k contributions up to a certain percentage (i.e. 3-10 % of your income) then it should be a no-brainer to do this. This is a guaranteed 100% return on your investment and forgoing this for 2-5 years when you are paying down debt is a huge amount of money in 401k that you will be missing. Yes, you should not be investing a lot of money while you are trying to pay off debt, but the 5% contribution in your 401k is not going hurt you.
The Bottom Line
I am not trying to diss Dave Ramsey, I respect and admire him as he ahs helped millions of people transform their lives financially. I just believe that is important to modify these two pieces of advice from him to reduce the chances of going into further debt and not miss out on your employer match.