Ok, now that you’re out of debt, you may be wondering what’s next? Invest in stocks? Buy some real estate? Hold on there a minute! The first thing you need to do is create some margin of safety, or “margin” in your life. This point is the crucial stage of setting a proper foundation for wealth building, and if you skip setting your foundation, you’ll create a house of cards that will fall eventually.
To establish a foundation for building wealth, you need an emergency fund with at least 3 months’ worth of cash to cover your normal living expenses. We talked about having a small emergency fund, equal to 1% of your salary, just in case something happens, i.e., car repairs, medical bills, etc. You need to expand this emergency fund first to make sure you don’t take a step backward should something go wrong.
You need a larger emergency fund than that, once you’re out of debt, to deal with larger emergencies that might happen, like a job loss, before you move on to buying a house and purchasing long term investments. The biggest risk you have of derailing your wealth building is having to raise cash when you fall on hard times. It’s much better to have a good solid reserve of cash to create a margin for you to live off of while you go look for and find another job. That way you don’t have to take the first thing that comes along, but can do a diligent search that will put you in a position for success.
The problem with having a house without cash is that you’re going to be in a world of hurt without cash to deal with a short term job loss. You’ll be unable to pay your mortgage, negatively affect your credit, and the stress will turn your house into a nightmare. In addition, once you own a home (as opposed to rent) there’s things that need to be repaired, with large price tags. You need to sock away cash to make this happen.
It’s also not a good idea to start investing until you have your full 3 months’ worth of emergency fund in place. The problem with focusing everything on long term investments is that you’ll need to raid these eventually to meet the needs of short term emergencies, and that’s not a recipe for success. If you think about it, oftentimes job losses correspond with recessions, when the stock market is down. That’s exactly the wrong time to liquidate your stocks to raise cash. If you’re a real estate investor, often those emergencies will happen when houses won’t sell or drop in value. For example, the temporary restrictions on evictions in the wake of COVID-19 caused many landlords heartburn, as they had to continue paying mortgages, despite tenants not paying rent.
There’s another problem to relying on investments to cover short term emergencies, and that’s taxes. As I’ll mention later, a 401K is a GREAT way to get started investing for retirement. However, the caveat is that there are tax penalties for withdrawing from a 401K prior to age 59.5. So not only could you reduce your investments available for retirement, but you’ll also have to come up with more cash to pay taxes. Not a good deal!
How much should be in your emergency fund? You need enough to cover your short term job loss needs as a start. This means a minimum of 3 times your monthly take home salary. However, you should try to keep saving some cash even after you reach that amount. First of all, it never hurts to have extra cash on hand to deal with a job loss. More importantly, when other emergencies or large expenditures come up, i.e., replace a roof, a/c, etc., you’ll have sufficient cash on hand. You should also be saving cash towards the purchase of new cars down the road, because your current car will wear out and will need to be replaced.
There comes a point where you’ve got too much cash, and that’s probably around 6 months of living expenses. The problem is that cash doesn’t earn anything. In reality, it loses money (safely) to inflation. While it is a great comfort to have plenty of cash on hand, there comes a point where it’s overkill.
My recommendation is that you do not invest until you get to three months of salary in your emergency fund. Then set aside 1-5% of your income to keep cash flowing into your emergency fund, so you can have cash available for large purchases. Never drop below 3 months, but shut down when you get to 6 months of your take home pay in that emergency fund.
Assuming you have some cash for an Emergency Fund, you’re ready to start investing. But let’s recap where you’ve come thus far. You started in debt, and now you are debt free. You’ve trained yourself to live off less than you make. You’ve got 24% (or more) of your income that you’ve trained yourself to commit to the future. That’s exciting, because now you’re ready to create a lot of wealth and stability for your family. Keep on the path, it’s about to get fun!