16 Dec Emergency Funds
When beginning a planning engagement, the first thing we evaluate is the adequacy of the client’s emergency fund. The reason is simple- without an adequate emergency fund, you are taking on more financial risk than necessary. Furthermore, at some point everyone needs to use their emergency fund. Here are some questions we commonly encounter on the topic:
What is an emergency fund?
An emergency fund is money that can be used in the event of loss of income or an unexpected expense. Loss of income can be the result of a lost job, decline in business, and injury or illness, to name a few examples.
An emergency fund should be the priority when someone starts to save. First-time homeowners who have nothing saved need to first save up a sufficient emergency fund before they start saving for a down payment. Homeownership is expensive and it is too risky to purchase a home without enough savings. Furthermore, the cost to access funds in an emergency can be very high; credit cards or pay day loans have interest rates that just compound the problem.
When do you use your emergency fund?
In the case of a decline in income, your emergency fund can be used for basic essential living expenses such as your mortgage, food, electricity. You can also use your emergency fund to pay for any unexpected expenses that may arise. Think about all the times in the past year you had an unexpected expense- home repairs, auto repairs, unexpected medical bills. The exact situation cannot be predicted, but the general costs can be planned for.
You should not use emergency fund savings for anything that you don’t need such as discretionary items. Your emergency fund is not a savings account for your next vacation or for impulse shopping. Although it is tempting to dig into your emergency fund when you really want something, you will be glad that you didn’t when your water heater goes out and you have money to fix it.
Why do you need an emergency fund?
According to a 2018 Federal Reserve report, 40% of American’s couldn’t come up with $400 in an emergency. What do they do if their home needs a major repair? Many people resort to some form of debt to pay these bills. It’s not uncommon for credit cards to be used as a “financial cushion”. This is an expensive way to pay for anything with many interest rates above 20%. An unexpected medical expense is stressful enough without having to go into some amount of credit card debt.
Feeling stressed about money is very common; in fact, 72% of Americans are stressed about money at least occasionally, according to the American Psychological Association. Having some amount of money reserved for emergencies can help lessen the financial stress that families may feel.
Where should you keep your emergency fund?
Keep your emergency fund liquid – in cash in a savings account. This is not money that should be invested as it needs to remain safe. You do not want to see your emergency fund losing value at the same time you need the money. It is preferable not to comingle emergency fund savings with your everyday spending money. This is another reason that having a separate savings account is a good idea- it will allow you a safe place to keep the money while you aren’t using it. It’s accessible enough if you need it, but it won’t accidently get spent.
How much do you need in your emergency fund?
The general rule of thumb is 3-6 months of living expenses saved in your emergency fund. This requires figuring out two things that vary depending on your personal situation. First, you need to know how much you spend each month on fixed expenses. Anything that you cannot cut back on or eliminate spending money on in the short-term will need to be considered a fixed expense. In the event you lose your job, you could eliminate certain spending categories such as meals at restaurants or shopping for clothes so you wouldn’t include those categories in your fixed expenses. However, you must keep paying your mortgage or rent and you will still have to buy groceries, so those categories would be considered fixed expenses.
Secondly, you need to decide how many months of those expenses you need. There is a bit of an element of personal preference and comfort that goes into this, but here are a few things to consider:
- Number of Incomes: A dual income household may be able to have less set aside than a single income situation.
- Uneven Cash Flow: If your income is commission-based or you own your own business with variable cash flow, you will want to have a larger amount saved. If your job provides with a steady and predictable salary, that may allow you to have less saved because it is easier to manage a budget.
- Type of Job: Think about how long you think it would take you to find a new job if you were to lose yours. If you have a unique job or talents and it might take more than 3 months to find something new, you would want to have a larger emergency fund to cover your expenses while you are job hunting.
- Personal Preference: Some people are just more comfortable having less saved. Likewise, others are very risk averse, in some cases preferring to save more than 6 months in fixed expenses set aside. Regardless of risk tolerance or other factors, we view 3 months of fixed expenses as the minimum goal for our clients.
How to Start Saving for Emergencies
If you are starting from zero with your emergency fund savings, it can seem impossible to save the total amount needed for your situation. Start with small goals and work up to your ultimate amount. Even having $1,000 set aside for an unforeseen circumstance will help reduce any financial stress you may be feeling. Once you hit the $1,000 milestone, start working toward $5,000 and so on until your emergency fund is fully funded. Every time you get paid, set aside a specific minimum amount. This should be the first place money your goes when you are paid. Pay yourself first. If you wait to save what is left at the end of the month or week, it is likely that you will spend everything in your account and save nothing.
We frequently give clients guidance on both emergency fund goal amounts and savings strategies to get there. If you have any questions or would like some guidance, don’t hesitate to reach out to us! We would love to hear from you.