CNBC published an article in January with a sad statistic: 60% of Americans cannot pay for a $1000 emergency such as an emergency doctor visit, car repair, or other emergency by using their savings. That means 60% of Americans are just a few weeks away from bankruptcy if they lose their main source of income.
If you hover around any personal finance forums, you have seen someone mention the Emergency Fund. Most people I’ve interacted with know about the concept, but usually it is executed poorly. Let’s fix that.
Defining the Emergency Fund
The emergency fund is just another word for a savings account that you use for emergencies. This is money we’ve set aside for the proverbial “Oh shit!” moment. Life is not about if things will go wrong, it’s about when they will go wrong. Something completely unpredictable or unplanned will happen to you. You’ll get into a car accident. You’ll get fired or laid off. Your cat will scare a squirrel up a tree, that squirrel will run out on a limb on said tree, put too much weight on a limb, cause that limb to fall down, bust a hole in your roof, and then fall on your cat.
That’s right. Your life is going to be shitty sometimes, and you need to be prepared for it.
Why do you need a savings account for emergencies? Don’t you have a credit card for that?
Right, because spending money you don’t have at a rate of 20% interest, which you can’t afford, is a good idea.
Wrong. “I didn’t know it was going to happen,” is never an excuse to use a credit card. Abandon that idea immediately. You need a store of cold, hard cash available to float you in times of need.
What Should You Use Your Emergency Fund For?
Different people define emergencies in different ways. Some people think it’s an emergency when their iPhone breaks. Other people don’t think it’s an emergency when they might have broken their foot after falling down some stairs. Different strokes for different folks.
I know I said “unplanned” earlier as an emergency, but I’m going to retract that now. In your finances, you shouldn’t have “unplanned” expenses. Christmas has been happening for a long time. Just because you forgot to include someone in your thoughts doesn’t mean it’s an emergency.
That also goes for routine maintenance on your car. Go look at your tires. Is the tread low? Can you already see the top of Abe Lincoln’s head when you put a penny in it? If it’s close, you know that you’re going to have this large expense in a few months. So you should start saving for it now.
If none of that stuff counts, what does?
Emergency funds are for things that are not predictable. Medical expenses. Dental expenses. An UNEXPECTED car maintenance issue. Maybe you got fired or laid off. You could also use to to buy a flight last minute if you’ve lost a loved one.
These are all very reasonable. In fact, you should use this money for those things. That’s what it’s for.
How Much Money Should I Have in My Emergency Fund?
Your first goal should be around $1,000. This will prevent you from having an immediate crisis for a smaller issue. What’s the overall goal, though?
In the reserves, we’ve got three groups of people: AGR, ADOS/ADSW, and M-Day (that’s someone who just shows up to drill for all you active duty folks). My rule of thumb is this:
If you’re AGR/Active Duty, with a good, stable income, 3 months of expenses should be fine. This should cover any emergencies and cover you for the time being if there’s a hiccup in pay or you have an unexpected expense.
If you’re ADOS/ADSW, which means you’re on active orders, but can be fired, you should have closer to 6 months of expenses. Why so much more? Because year to year, you may not have a job. A lot of factors can affect that, and you know that every September, soldiers start getting a little antsy about next year’s budget. You should be ready for this before it happens.
If you’re M-Day, it’s going to depend on what type of employment you have. Do you have a cushy government job where you have all the job security in the world? 3 months of expenses might be just fine. Are you a contractor and work for 6 month stints here and there? You may need up to 12 months of expenses.
Ultimately, you need enough money in that account that you can sleep well at night.
Note here that I’m saying expenses, not income. While it’s a lofty goal, saving up to your income is not usually necessary. The key here is that you need to know what your expenses are. Ball-parking it is completely unacceptable when it comes to your financial future.
Write. It. Down. For this purpose, I recommend creating two budgets. One is what you typically spend on a month-to-month basis. Multiply this number by 3, 6, or however many months of stability you’re trying to achieve. That’s your Emergency Fund Savings Goal.
The other budget is a complete austerity budget. Cut everything you don’t need to survive. Entertainment, cable, dining out, morning coffee. This budget is bare-bones survival. This is handy to have just in case, so you know for how long you can stretch your emergency fund.
Don’t put Your Emergency Fund in Your Primary Bank
One of the biggest mistakes people make with their emergency fund is putting it in their primary bank. I know, it’s soooooo convenient to have the balance right beside your checking account, but personal finance isn’t all about numbers. It’s about controlling your behavior and emotions.
Put that money in another bank. I recommend picking a High Yield Savings account at a reputable bank to store it in. Your bank probably offers terrible interest rates, and current rates for a High Yield Savings can be above 2% as of the writing of this article. It’s not much, but it means your fund will be adjusted for inflation
Out of sight, out of mind is the rule when it comes to emergency funds. Set it up your monthly transfers to it, set your goal, and then forget about it.
How to Build the Emergency Fund
$1,000 or 3 to 6 months of living expenses may sound like a hurdle at first, but the important part isn’t the speed at which you build it, but that you start building it. Even $50 a month is a good start and will start you on the path. Making little decisions now will pay dividends later. Especially if you use a High Yield Savings account.
Refer back to the budget you created while building your monthly expenses. Hopefully, your monthly expenses are less than your income. If so, identify a portion of your leftover income, and automatically allocate it to your emergency fund. Doing this automatically is key; I’ve noticed over my financial history that I save way more when I remove myself from the process.
Once this is on auto-pilot, quit thinking about it. Let it build in the background while you focus your energy on optimizing other parts of your finances.
Got something else to add?
Write a comment below about a misconception you had, or something you’d like me to add as an article! You can also e-mail me at ReserveFI@gmail.com