Millions of people and households struggle with debt, and there are various ways offered to help dig out of it. I’ve long felt that the main reason why people have debt problems is because of a lack of savings.
If you don’t have savings, you’ll be forced to rely on credit anytime you’re short on funds. That virtually guarantees a lifetime of debt! Sure, you might get out of debt in the short run, but the absence of an alternative to credit will bring you right back—sooner or later.
The ultimate answer to getting out of debt, I believe, is by becoming a saver. Once you make that transition, you become a lender, not a borrower (Deuteronomy 15:6).
But how do you get started, especially if you’ve never been a saver?
The Debt Snowball
Probably everyone has heard of the “debt snowball”, popularized by Dave Ramsey. By using the debt snowball method of getting out of debt, you start by paying off your smallest loan first. Once that’s paid off, you move on to paying off the next largest loan.With each loan that’s paid off, you have more money to concentrate on paying off the next largest loan. In this way, your debt pay off plan starts small and grows larger as it rolls forward—that’s exactly how a snowball builds.
We can take the same snowball action and apply it to savings–call it a savings snowball.
For most non-savers, the biggest obstacle to saving is getting started. It would be great to start with $10,000 or $20,000, but the only way to get there is by doing it a little at a time. That’s where the savings snowball comes in. You start building a small account, one with a balance that’s very achievable, and only then do you move up to building an account that might need a larger balance. But once you have a small account fully funded, building a bigger one won’t seem so daunting.
Start your savings snowball with an emergency fund
For most people, the best way to start is with an emergency fund. Not only is it a relatively small account, but it’s also one that’s incredibly important to have.
There are various recommendations when it comes to the size of an emergency fund. Dave Ramsey has recommended starting with $1,000. To my thinking, that’s far too small for an emergency fund—a typical high end car repair will eat that up in a single swipe. However, if you have no other savings of any kind, $1,000 is an excellent place to start.
And it works perfectly as the start of a savings snowball. You’re beginning with a relatively small snowball, but that paves the way for greater savings as you roll forward. After all, if you can save up $1,000, you can just as easily save it up to $2,000. In fact, the second thousand may be easier just for the fact that you’ve already done it!
Personally, I think that 30 days of living expenses is the minimum effective emergency fund you should have. Not only will that amount cover most major expenses, but it will also provide sufficient funds to live on in the event of a job loss—at least until unemployment checks begin arriving (there’s usually some kind of delay with those).
From there you can build up to what ever amount makes you comfortable. And then you can continue moving the snowball forward to larger savings goals.
Then go to an intermediate account
One of the better reasons to have an emergency fund is that it can make saving for larger purposes easier. Not only do you have a savings foundation that you can build on, but you also have money to insulate you from emergencies while you’re saving for bigger goals.
The next type of savings in the snowball then might be building reserves for a near term goal, like a down payment on a house or buying your next car. An account that size will almost certainly be larger than an emergency fund. How much you’ll need will depend on what it is you want to use the money for. A vacation fund may only need a few thousand dollars, but a home down payment may require $10,000 or more, maybe a lot more.
But once you have an emergency fund, building a more substantial account will mostly be a matter of making the snowball bigger.
Move up to retirement savings
Most financial planners will advise that you start your savings with a retirement account. This is especially true if you can participate in an employer sponsored 401K plan with some sort of company match on the contributions. Not only does it build savings quickly, but since it’s usually dominated by growth type investments you can take advantage of the compounding of investment returns, and do so within the tax deferral feature of the account.
I’m going to risk committing a personal finance heresy here by saying that I don’t believe this is the right approach for everyone, particularly those who have no savings otherwise. Here’s why I think this way:
- A retirement plan is not an emergency fund; it’s a very long term investment account that specifically should not be tapped for short-term needs
- If you have no savings outside of a retirement account, it will be just a question of time before you’ll need to tap it for some reason that has nothing to do with retirement
- If you do withdraw or empty the account before you turn 59 ½ for any reason not approved by the IRS you will not only have to add the amount to your taxable income but you will also have to pay a 10% early withdrawal penalty on top of that
- If you’re building your retirement assets then relying on credit to meet short-term funding needs, you’ll be effectively creating a margin loan against your retirement plan if your debts grow even as your plan balance grows
- A big drop in the financial markets can wipe out a lot of retirement plan assets in a short amount of time
- Just as you should diversify between investments, you should also diversify between different types of savings accounts
A retirement plan isn’t a general purpose savings plan; it’s a plan designed to cover a specific need. Other needs should be covered by other dedicated savings accounts. If you can’t adequately fund short-term needs and goals, the long-term plans—like retirement accounts—may not work out the way you hope.
And it all starts, one small account at a time—the savings snowball.