The Seven Steps of Financial Preparedness

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Seven Steps of Financial PreparednessWhen a hurricane threatens, making a plan and gearing up for emergencies is imperative. Economic emergencies happen too, but it may be less obvious how to prepare. Here are seven steps you should take to weather any financial storm.

Step 1

First, put $1,000 aside. It doesn’t amount to a real emergency fund, but it will do until you get your finances in order. You can accumulate the $1,000 by allocating $10 a day for just over three months.

Most people go into debt because they live hand to mouth, spending 100% of their take-home pay. Then life happens: The car breaks down, the roof leaks or someone needs medical care. Without $1,000 in the bank, families spend the money anyway and go into debt. Having a mini-emergency fund can help you get out of debt and stay out of debt.

Step 2

The second step to prepare for financial emergencies is to extricate yourself from credit card debt–forever. These first two steps are part of Dave Ramsey’s financial peace course, offered in churches around the country. Ramsey suggests paying off your credit card by starting with the smallest balance in order to achieve small successes and then working to snowball your payments as you tackle the larger balances.

He also notes that the only way to get out of credit card debt is to adopt the intensity of a gazelle whose very life depends on outrunning the cheetah. If you are in debt, I highly recommend Ramsey’s financial peace course. To be notified about the next course in your area, send your contact information to us at

Step 3

These first two steps, having $1,000 and paying off debt, simply prevent you from facing a financial emergency by starting out wounded and bleeding. The third step is to improve your ability to handle fluctuating monthly expenses.

Set up a monthly budget so your day-to-day expenses are less than 65% of your take-home pay. No matter what your income, living off a smaller percentage of what you earn is the way to grow rich and be better prepared for financial emergencies. The difference between those growing rich and those remaining poor is not the salary they make. It is the salary they keep.

Relative to their income, the rich are frugal. They save and invest. They spend less than 65% of their take-home pay on day-to-day expenses. They save at least 10% in their retirement accounts and another 5% in taxable savings. They direct another 10% toward unknown big purchases. And they even live frugally enough to give another generous 10% to charities.

Setting aside 35% for unanticipated expenses is the minimum. When my wife and I first started our life together, we did not make very much. But we still lived off about half of our take-home pay. We were fresh out of college and did not have a very high lifestyle. After starting a family it becomes much more difficult, but not impossible, to save money. Remember that even if you don’t earn very much, probably a family somewhere is living on half of what you make and doing just fine.

If you are well off, you can set your sights even higher. Think of learning to live frugally and still be content as part of the emotional training you need to weather a financial storm. That training starts with living within a budget even when financial conditions are good. Some productive families live off less than 15% of their take-home pay and still save, invest or donate generously with the other 85%.

Frugality is a skill needed to live a good life. It is a mindset best learned from parents, but even if yours were spendthrifts you can reeducate yourself and learn to view money differently. The poor buy things; their homes are cluttered with them. The middle class buys liabilities on which they have to make payments, such as second homes, luxury cars and boats. The rich buy investments that pay them money.

If you want to break your poor or middle-class mindset and learn how to be frugal, help is available. In addition to Ramsey’s course, I recommend Dana Adams’s blog “Mrs. Moneymaker”, which describes where to find deals, both locally and on the Internet, that will stretch your family’s budget. Not only will these suggestions save you money, but the mindset of frugality is contagious and will help you overcome any bad habits you may have learned growing up.

Once you’ve set your budget so money is left over after paying the bills each month, in step 4 you automate your cash flow to promote saving and investing.

Step 4

Every month, have 10% transferred into your retirement account before you receive your paycheck. Then automate the transfer of 25% of your take-home pay into an investment account a day or two after your paycheck is deposited. Automating your savings makes savings a high priority and ensures that you pay yourself first. This investment account will grow over time, and you can use it to pay for big emergencies and charitable gifts.

Keep the balance in your checking account between two and three times your monthly expenses. If you are paid monthly, your bank account should cover two months of expenses the day before you are paid and three months the day after. You’ll have both a generous cushion for your checking and money for unexpected repairs or big purchases. Whenever your checking account exceeds three months of take-home pay, consider moving some of it into a higher paying investment.

You need an emergency fund in case you are unemployed. The first three months of the fund are safe in your checking account. Now invest an additional three months in vehicles you could easily sell within 90 days. Your emergency fund investments should not be in a retirement account, but they do not need to be in a money market account. Many people use no-load, no-transaction-fee mutual funds. They should also be stable enough to guarantee three months’ worth of expenses. Therefore if your emergency reserve funds are large enough, you can diversify them fully into investments that fluctuate more but pay a higher rate of return.

Step 5

Step 5 is creating an asset allocation for your investments that’s diversified for safety while being invested for appreciation. Diversification works, and it’s never more obvious than in times of market turmoil.

Without diversification, portfolios can have a zero return over a decade. After being well diversified, the likelihood of no return over a decade drops significantly. Your asset allocation should be a guideline in times of trouble. Whenever you are worried or glad about what is happening in the markets, rebalance your portfolio back to your target asset allocation.

Rebalancing means buying stocks after they have gone down and selling stocks after they have gone up. This contrarian move is always wise. When stocks are hitting new highs, rebalance. When stocks are making new lows, rebalance. Studies suggest that the simple act of rebalancing annually earns about a percentage and a half more.

Step 6

The sixth step toward emergency preparedness is using your taxable investment account properly. You are putting in 25% of your take-home pay each month: 5% is taxable savings and should start to accumulate real wealth, and 10% is for charitable gifting. Each month you buy investments, some will grow in value and become highly appreciated. Each year, find the investments that have appreciated the most, and use these for your charitable contributions.

Done properly, this method of annual charitable gifting plants the seeds for gifts that may not be realized until ten years later. Thus your charity can survive for ten years after you have stopped contributing on the front end.

The last 10% is for unknown large purchases. If your first response to this suggestion is to ask, “Like what?” the answer is “Exactly.” Most people who run up credit card debit keep their regular spending within 100% of their take-home pay until some unexpected expense causes them to deficit spend. You can’t anticipate unknown unknowns, so the best you can do is set aside some money to cover them when they arise.

Having the discipline to budget for small financial emergencies will help you be prepared when you encounter larger financial crises. When some unknown spending need strikes, take the money to cover the expense from your growing emergency fund. Then, determine if you have been budgeting for this level of unknown expenses adequately.

You should be able to budget for car repairs, medical bills and house repairs. If the expense truly swamps what you have been saving, you may need to increase the amount to better anticipate the level of emergencies.

Step 7

The seventh and final step is mobilizing during an actual emergency.

In a real financial emergency you should have two to three months of spending in your checking account and another three months in your taxable savings. You should have a pile of money for large unknown purchases (that 10% of your pay) and another pile of taxable savings (that 5% of your pay you have never touched). Finally, you should have been planting seeds toward future charitable gifting that will last through the next decade.

Usually emergencies don’t happen. So the money you have socked away makes more money. Keep an emergency fund for several years and it should double in value, giving you an additional emergency fund. Whether you need it or not, being prepared for a financial emergency means peace of mind, knowing that your lifestyle is sufficiently frugal so you won’t be in trouble.

Follow David John Marotta:

President, CFP®, AIF®, AAMS®

David John Marotta is the Founder and President of Marotta Wealth Management. He played for the State Department chess team at age 11, graduated from Stanford, taught Computer and Information Science, and still loves math and strategy games. In addition to his financial writing, David is a co-author of The Haunting of Bob Cratchit.