Basics
Before we get into the details of creating a “golden reserve”, that is, emergency savings (“emergency fund”) and before we start talking about debt repayment, it is important to cover the basic and necessary items in our budget.
This means that it is important that you first cover the expenses you know for sure you will have and which recur from month to month.
These include food expenses, overheads, rent – everything you have to pay to survive a month. This also includes installments you have to pay for loans, credit cards, overdraft, etc.
According to the 50-30-20 budget rule, these items would fall under the cost of needs.
Once you have covered these costs, you can move on to the next steps.
Unforeseen expenses
The most interesting thing about unforeseen expenses is that they are not so sudden, because we usually know that they will occur at some point. We just don’t know exactly when. Car repairs, service, dentist, home repairs, or repair of some device, etc. For that reason, it is good to prepare a fund in advance for these costs – a golden reserve from which you will take money if needed.
Why is it important to cover basic expenses and have a reserve?
We can easily see why paying our monthly bills is our top priority: we need a place to live and food to survive.
But there are still other costs that arise. It is hard to set aside money in advance for car repair or a dentist when everything is fine, and yet we are fighting debts!
If you don’t have a fund for car repair, a dentist, etc., then these “unexpected” situations can easily lead to a new debt, that is, you run the risk of falling into a (new) debt. Of course, the fact is that if you first create a golden reserve, then the existing debts are still there and you pay interest on them.
And here we come to a multiple dilemma: should we first pay off our debts or create a golden reserve, and how much should our reserve amount to?
How much should our “golden reserve” or emergency fund amount to
This is an important question that affects the whole dilemma.
Different experts have different opinions, but let’s say that this amount ranges from 3-6 months of your basic expenses, or 6-12 months of basic expenses. It is important to note here that these are basic – minimum costs that you have to pay, and not your standard costs.
The number of months in which you plan to create a golden reserve should be in line with your estimate of how many months your basic living expenses will be covered in the event of losing your job, etc. You estimate that on the basis of how quickly you can really find a new job, etc. Entrepreneurs also need to bear in mind different situations – what if their income drops, or what if, for example, they cannot do their job for a while due to illness. Those months need to be covered somehow.
First steps and answer to the dilemma
Before the above calculation throws you into thinking and discourages you, take a look at the steps recommended by people who are experts in this topic.
1) First, create a MINI fund for unforeseen situations
Dave Ramsey recommends that people create a fund of at least $ 1,000 (his target group is people in the United States, so keep in mind that this amount is his recommendation for people in a country with a higher income). Others say that it is convenient to have the amount of one month’s expenses for this minimum fund.
So, as the first step, it is useful to create an emergency fund with a small amount (set yourself an amount), and then to create a reserve for 3-12 months as a later step. When you have a basic fund, it will most likely give you a basic sense of security.
2) Pay off debts
When you have a basic fund or a “nest egg”, the next step is to pay off debts.
Without going into a deeper analysis of debt repayment strategies, these strategies come down to first starting to repay either:
- debt with the highest interest, or
- the smallest debt.
If you have debts on which the annual interest rate is high, then you will save a lot on interest if you focus on debt repayment.
When you use credit cards or overdraft, borrowing usually carries quite high interest rates. See here the report of the National Bank of Serbia on the average annual interest rate for overdraft. As you can see, it is about 28% a year. On 50,000 dinars of overdraft there is an annual interest of 14,000 dinars.
If you use the largest debt repayment strategy, you can potentially save the most on interest if you are persistent in repaying. The strategy of repaying the smallest debt first has an advantage of positive psychology, because repaying even a small debt in full will motivate you to continue repaying the next one.
3) Save for the remaining part of your golden reserve
At one point, you come to a situation where you only have, for example, a housing loan, a student loan or some other debt that has a relatively low interest rate.
Then you can continue to direct part of your budget to create a golden reserve for several months of your expenses. It is important to set a specific amount, as I described earlier.
Some banks pay interest on a vista savings (when you don’t have to deposit money), so you can explore this option as well, while some banks have a term savings option where even in case of cancellation (when you stop saving) you still have part of the interest.
4) When you have created a golden reserve
When you reach the set amount of your golden reserve, a new question arises: whether to repay debts that have lower interest rates or to invest money instead.
In the process of creating savings and paying off debts, it is important to look at the bigger picture, to work on your mindset, look for solutions and new opportunities. Don’t think only in terms of your current earnings, but also think about how you can create additional earnings at least until you achieve your goals. As with everything when it comes to personal finance management, it is very important that you find the model that best suits you and your financial situation.
Share with me your ways that have helped you.
Do you want to take control of personal finances?
I am at your disposal for financial coaching. If you have any questions or want to schedule a coaching session, feel free to contact me here.