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March 16, 2005

The Context of Savings:
E-funds and Freedom Accounts

Several days ago I received an email from a reader named Mindy. She had some questions regarding the different types of savings accounts which I mention on this site:

I found your site in the first place by doing a Google search for "Dave Ramsey's $1,000 emergency fund." I wanted to find out just what exactly the emergency fund is for. For example, I believe he says it could cover a car repair. But as you point out on your IYM site, a car repair should not only be expected, but saved for, in the Freedom Account.

If you have any good advice on how to differentiate the two, that would be great.

I'm even starting to realize that a Savings Account is a third animal altogether. It used to be that I thought that an emergency account, freedom account, and savings account were one and the same (which has gotten me into trouble; i.e., no money for a vacation? But $1,200 in the emergency account? Presto — we'll just use the $1,200 that was in the emergency account for plane tickets, and ah, we'll just put the hotel on the credit card, no problem — rationalizing that I was being somewhat good because I'd paid for the plane tickets free and clear, and that paying for hotels on the credit card was not such a big deal, comparatively speaking).

I also find myself confused about which comes first: Is it putting money in a Freedom Account? Is it paying off consumer debt? Is it making an emergency fund? Is it making a savings account (and save for what, exactly?)?

Since I think it's quite possible that others might have these same questions floating around in their brains, I would like to discuss the topic publicly.

In Dave Ramsey’s world, there is no “Freedom Account” per se. Or, at least, he doesn't mention such a savings account specifically. Dave relies purely on an “Emergency Fund.” In his world, it would be there for car repairs, home repairs, and such. He does mention, however, that one should save up for things like Christmas (“Christmas is NOT an emergency!”) and clothing. He just doesn’t go into how this might be done.

The "Freedom Account," on the other hand, is a Mary Hunt thing. I first came across it in her book Debt-Proof Living. (She's also the creator of The Cheapskate Monthly.) Mary Hunt also refers to an emergency fund, too, but hers is called a “Contingency Fund.” This is, in her words, a “…pool of money set aside for major catastrophes.” So where Dave's "emergency fund" and Ms. Hunt's "Contingency Fund" are concerned, they're basically the same animal.

The Freedom Account has a different purpose, however. And after reading all the material that I have in the last several years, I was really drawn to the way one could conceivably make e-funds and Freedom Accounts work in concert to build a super-strong savings foundation. With that in mind, here is how I use them to operate, at a base level, where my finances are concerned:

Emergency Fund:   It’s there for things you didn’t (or can’t) anticipate. Mine happens to be in my credit union savings account.

Freedom Account:   Mary says it’s for “irregular, unexpected, and intermittent expenses.” It's a sort of accrual account, set up to save for things you can and should anticipate … expenses which you know are coming at some point in the future. (My Freedom Account is held in an ING Direct savings account.)

Personally, I further break my Freedom Account down into “Committed Funds” (those subaccounts which I use to save up for things like annual life insurance payments, six-month auto insurance payments, quarterly house alarm payments, etc.; i.e., money that is committed to being spent at a specific date and time) and “Noncommitted Funds” (subaccounts used to save for house repairs, car repairs, insurance deductibles, gifts, education, and appliances / electronics; i.e., items with no specific set date for usage).

By the way:   When I talk about “savings,” I’m just using that as a general term to encompass both my Emergency Fund and Freedom Account. One could have a “Savings Account” for more discretionary items, I guess, like kick-butt Nikon cameras, family vacations, and so on. Or one could just set this up as “Noncommitted Funds” inside a Freedom Account. It’d work fine either way.

Now when I say I want to have, say, $9,000 set aside in my e-fund, what I really mean is that that’s the total I want to see when I add my Emergency Fund account to the portion of my Freedom Account that is classified as Noncommitted Funds. I may have $1,300 saved up in Freedom Account subaccount “Car Repairs,” but these are Noncommitted Funds. If I'm in a really tight money spot, then I could always slide that money over to use for extra-large house repairs if I have to do so.

I divide my Freedom Account savings into “Committed” and “Noncommitted” subaccounts because (1) I just like the idea, (2) it helps my brain compartmentalize things, and (3) ING Direct pays me a much better interest rate than my credit union, so I keep as much money there as is reasonable and efficient. In reality, if money is saved as “Noncommitted Funds” in my Freedom Account, and it has no specific intended purpose or set date for expenditure, then it’s really just a branch of my total e-fund.

I may be entirely off-base by looking at it this way. Maybe what I SHOULD do is have four months’ worth of expenses saved in my Emergency Fund in ADDITION to the total that’s in my Freedom Account (counting both committed and noncommitted funds). If that’s the case, then I’m a LONG way from where I ought to be.

Does all that make sense? My wife continually asks why I make this so complicated for myself. My answer is that it works for ME. I am a control freak. I like assigning purpose to my money — sort of tidying it all up in desk drawers, I guess.

I just glanced back at Mary Hunt’s recommendation for a “Contingency Fund,” and she suggests keeping a flat $10,000 in that. “Financial experts typically suggest a family needs the equivalent of three to six months’ living expenses in reserve,” she writes. “I find that recommendation too nebulous and prefer to … suggest a fund of $10,000. That seems about right for the average family. If your monthly expenses are high, however, you should adjust the amount to cover what you would need to live for a full three months without any income.”

So it is very akin to Dave Ramsey’s “Emergency Fund.” And Mary says you should have the “Contingency Fund” in ADDITION to the “Freedom Account.”

But hang on. She goes on to say: “Think of your Contingency Fund as your personal debt insurance. Its short-term purpose is to give you an alternative to using credit to cover emergencies like auto repairs and medical bills for which you are not otherwise prepared.” So really, it DOES encompass what I call my “Noncommitted Funds” inside my Freedom Account. I’m not so far off after all!

As far as “what comes first,” well, that depends which money guru you want to follow. If I had to suggest a plan for someone right now, it’d be pretty similar to Ramsey's "Baby Steps," and would read like this:

1) Figure out your irregular, intermittent expenses; i.e., the “Committed Funds” part of a Freedom Account. Determine their equivalent monthly amounts. Start depositing this money monthly into your Freedom Account, just as you would any normal monthly bills.

2) Step away from the cliff: Save $1,000 as quickly as you can. Meanwhile, make minimum payments on your debts. This is your beginning Emergency Fund.

3) Pay off the debt. Pay off the debt. Pay off the debt.

4) If something happens and you have to dip into the Emergency Fund, go back to (2).

5) If your employer offers some sort of decent match on a tax-advantaged retirement account (like 401k), contribute just enough to get the maximum match.

6) Complete your Emergency Fund savings and fill out whatever else you need to in your Freedom Account. As for the e-fund, target whatever amount makes you comfortable … $10,000 flat, or 3-6 months’ worth of expenses.

7) Max out your tax-advantaged retirement savings vehicles.

And so on.

As always, if anyone has questions or comments, feel free to email me!

Michael | March 16, 2005

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