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Welcome back to the Roadmap to Financial Health! If you are new to the Roadmap, we recommend starting at Step 0.
We live in a society of chronic over-spenders driven by a media that equates luxury goods with success, schools that don’t teach us to manage our finances, and parents that largely don’t know how to (not their fault, no one ever taught them either!). The main problem with this system is that it doesn’t lead to greater happiness. It mostly leads to added stress.
76% of Americans live paycheck to paycheck. Almost 50% of American households that make $100,000-$149,000 a year (a large segment of the “middle class”) have less than $1,000 in their checking and savings accounts combined.
So what is an Emergency Fund for?
Well, emergencies. An emergency fund is primarily to cover your expenses if you or your spouse suffer a job loss or have a particularly large expense arise. If you don’t build a strong emergency fund while you are in a good employment position when disaster strikes you will likely end up taking on debt. That debt will extend your recovery from the layoff far beyond the amount of time it would take you to replenish your cash emergency fund. 20% credit card interest rates are truly as bad as they sound. That monthly bill will weigh on you, even when you’re back on your feet.
As we discussed in Step 1.2 on building a strong budget, you should already have money allocated in your budget for normal medical expenses and home and auto repairs. Things like copays, the car needing new tires, or needing to call a plumber to fix your water heater. But your emergency fund will be your safety net for high dollar, unexpected expenses. When the heat shuts off in January and you find out you need a new boiler, lean on your emergency fund, not your credit cards.
How much do I need?
A good rule of thumb is 3-6 months of expenses. 3 months is reasonable for people with stable jobs, households with two working adults, or people in higher demand careers that should be able to get back to work quickly. However, keep in mind that on average it takes 1-2 months to find a job in a strong job market, and if you get laid off, the market probably isn’t booming. 6 or more months of an emergency fund is ideal if you work on commission, depend on overtime that could be shut off, or are a one income family.
As you save for your emergency fund, stay focused on how much less stress money will be when you aren’t trying to figure out how to get from one paycheck to the next. Getting to the emergency fund you need isn’t going to happen overnight, but each time you put money into it you’ll be able to breathe a little easier. Soon you’ll be able to confidently set your budget for June on June 1, because you’ll just be starting to dip into last month’s paychecks!
If you are the average American living paycheck to paycheck, 3-6 months of savings might feel insurmountable right now. You may have thought in the past that if you ever got laid off you could just borrow from your 401(k) or take out some debt and you would put it back as soon as you got back to work. The problem is, as a society we are already significantly under-saving for retirement, so leaning on your retirement account is just kicking that can of financial stress down the road. And even if you can pay double the monthly payment on that credit card debt once you get back to work, at +20% interest it will still take you almost 2 years to dig your way out of that hole. Trust me, building your emergency fund is much easier.
What if you’re in debt?
A common question from people just beginning their journey to financial health is how to prioritize their emergency fund and paying down debt. This depends somewhat on what kind of debt you have. If you have credit card or other high-interest rate debt (north of 10% APR), my recommendation is to get at least $1,000 set aside for emergencies and then pay down your debt as aggressively as possible. If your debt is mostly fixed rate loans in the single digits, like most auto loans or mortgages, focus on getting your emergency fund to at least 2 months and then attack your debt.
We will talk more about paying down debt in Step 3 of the Roadmap to Financial Health, but having no emergency fund at all before slashing your debt is a good way to get frustrated. If you give yourself no cushion and only pay down debt, when the car suddenly needs new tires or you have to take a week of unpaid leave to take care of your sick family member, you’ll immediately be leaning on credit again and you could end up feeling like all that belt tightening was for nothing.
How do I save for this?
If you built a strong budget, you already know that the cash you have available each month after your Monthly Obligations, Debt Payments, and True Expenses is the money you can use for savings goals. Building your emergency fund should be your first major goal if you are first starting out and you should be sure to allocate some money to it every month.
Building the first month of emergency money. You can build the first month of emergency money by tricking your mind as you allocate money in your budget. Put a little more money than you plan to spend in each category for Monthly Obligations and True Expenses (and Quality of Life categories if you can), but don’t spend it.* Let that amount of extra money roll over to the next month. When on the first of the month all of your categories are already fully funded, before you’ve even allocated money from the month’s paychecks to them, you will have your first month of emergency money and will have escaped the paycheck to paycheck cycle! From then on create an Emergency Fund category in your budget and add to it directly every month.
*Example: If your cell phone bill is $120 each month, put $140 in it every month, so that each month you have $20 left over. In six months you will have a month of emergency cushion for your phone bill!
Where do I keep it this money?
As you watch this money build up in your checking account, you’re probably going to start wondering about all those investment ideas you’ve heard from family, friends, and colleagues. “Should I buy some stock in Apple? Invest it in a mutual fund? I saw something in the paper on REITs…” This is when you have to remember the all encompassing rule of emergency funds.
This is money is for your financial health and security, not an investment.
Every investment comes with risk, so when you buy stocks, bonds, mutual funds or any investment product, you have to be prepared for that money to potentially decrease in value as well as increase. Also, any money you may need in the near term shouldn’t have huge downside risk and shouldn’t be difficult to access quickly.
Your emergency fund needs to be secure (risk-free) and liquid (quickly and easily accessible). I recommend keeping the first 1-1.5 months of saving in your checking account, and the rest in a high interest savings account. The growth in interest will be minimal, but you also won’t wake up to see that money gone when you need it.
If you already have more than a month and a half of savings for your emergency fund, NerdWallet has a great overview of the Best High Yield Savings Accounts for 2017.
Do you have an emergency fund? Do you feel like your budget is prepared for any expense? Let me know!
Read the next step on the Roadmap to Financial Health here: Step 3 – Destroy Your Debt.