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The biggest challenge to taking control of your personal
finances isn’t having too little money, or owing too much, or even lacking
information on how to gain that
control. The reality is? For far too many people, caring about this type of
thing just isn’t sexy. By reading The Bill Stark Blog you’re already well ahead
of your average American and in today’s installment we’re going to talk about
that oft overlooked, highly critical, super important, totally unsexy key to
gaining control over your financial wellbeing and future: the emergency fund
and its cousin the emergency cushion.
What’s an emergency fund?
Quite literally we’re talking about a fund of money you keep
set aside to help pay for emergency expenses you haven’t accounted for in your
budget. (You are using the most powerful financial tool in the world, aren’t you?) Anything surprising
and unexpected that you can’t afford from your monthly pool of cash that pays
for your living expenses can qualify as an emergency fund expense. Typically
this is something like a sudden car repair after a fender-bender, or perhaps an
emergency medical expense when your daughter breaks her arm at football practice.
These types of expenses are sudden, significant, but necessary.
An emergency fund is absolutely not the pool of money you use to buy things you want simply because there’s an amazing
pair of boots on sale at the mall, or HSN has that lightsaber replica you’ve
always wanted on double discount. A good metric to use for your emergency fund:
will my family be harmed if we don’t pay for this unexpected expense? If the
answer is yes, feel guilt free about dipping into your emergency fund. If the
answer is no (and you have to be honest with yourself!), then it’s something
you save up for outside of your emergency fund.
Emergency fund versus emergency cushion
There are two types of emergency funds: the full strength
emergency fund and the smaller emergency cushion. In the 10 Step Plan to Your Financial Future I speak to both and the order in which
you save for them is first filling out your emergency cushion and then later
fully funding your emergency fund. That’s because the cushion is exactly that:
a small buffer to provide some protection while you get your financial house in
order.
Once you know where your money is going, step one of the
plan, it’s important to build yourself a buffer so that a sudden small expense
doesn’t derail the accomplishments you’re trying to make paying off debt and
saving for the future. My recommendation, the same as other finance gurus like
Dave Ramsay, is to save up $1,000 before taking advantage of your employer’s
401k match and paying off high interest debt (steps 3 and 4, respectively). The
reason? The $1,000 threshold lets you handle a good percentage of sudden
expenses while you focus on the other steps in the plan. That means while you’re
knocking off that credit card using the avalanche method or finishing your student loans using the snowball method a sudden expense you hadn’t budgeted for can be managed
with your emergency fund so you don’t have to worry about adding more debt to
handle that surprise.
Switching from emergency cushion to emergency fund
Once you’ve saved up your emergency cushion you’ll
transition to maxing out your employer’s 401k match and paying off your high
interest debt. When that’s done? It’s time to max out your emergency fund. A
properly funded emergency account includes 3-6 months of living expenses
dependent on your income status. If you live in a double income household in
which you and your partner both earn an income, three months of expenses is a
pretty safe total. If you’re relying solely on your own income, six months is a
safer bet. Why so much? Because an emergency fund isn’t just about short-term,
surprise expenses but something more significant: the permanent loss of income
that happens when you lose your job.
How important is your emergency fund? Fully funding mine is the best career decision I’ve ever made. It provides you the security of
knowing that if you or your partner loses their job you’ll be safe in paying
your bills until you find a replacement source of income. As for those sudden,
unexpected monthly expenses that come up from time to time? With 3-6 months of
savings you know you’ll be able to afford those too. Fully funding your
emergency fund may not be sexy but in addition to being the best career
decision you’ll make it’s also a huge mental relief. Imagine not having
month-to-month financial stress because you know
you can handle whatever life throws your way! That’s a pretty extraordinary
piece of mind and when you consider financial concerns are the number one source of divorce in the United States, your emergency fund is essentially an inoculation for your
marriage. Not bad for something so “boring”!
Emergency savings and high interest debt
The 10 Step Plan is all about paying down debt aggressively
and for good reason. When you have outstanding debt the most powerful force in the universe is working against you. So how do you
save for emergency situations while also working on getting rid of your debt?
Follow the 10 Steps by figuring out where your money is going and then save up
your emergency cushion. You’re obligated each month to pay the minimums on your outstanding debts so
make sure you account for those in your monthly living expenses while
budgeting.
Once you have your emergency cushion saved up to the tune of
$1,000 you can follow the next steps: maxing out your employer’s 401k match and
paying off your high interest debt (anything over 5%). It’s when those steps
are finally completed that it’s time to shift to putting together your
emergency fund. Following these steps allows you to manage your debt situation,
secure yourself against surprise expenses, and still put together a full
emergency fund as quickly as you can afford.
Where to keep emergency money
So now that you’re working towards saving up your emergency
cushion followed by your emergency fund, where exactly are you supposed to store them? The location in which you
keep your emergency funds need to meet the following criteria:
·
The funds must be relatively liquid, which means
you can quickly access them as cash
·
The funds must be protected from risk exposure
·
Earning interest on the funds is less important
than meeting the first two criteria
What does that mean in practice? When you need to reach your
emergency funds, you need to do so quickly. Having to break a certificate of
deposit (CD) to get the money means you don’t have access to it immediately and
you’ll be assessed a fee to get to the cash. Keeping the money in an investment
account means having to liquidate assets to turn the fund into cash, which
takes time and could also cost you a tax penalty. Putting the money into a fund
that invests it means taking on the risk that the total cash available to you
when you need it may be less than when you put it in which could spell disaster
for paying surprise costs or covering your salary after a sudden job loss.
Those of you reading who are thinking, “But if I don’t
invest the money, won’t I lose value due to inflation?” And the answer is yes! (Also,
congrats to getting to the point where you’re considering maximizing the value
of each and every dollar. That’s an awesome step!) For your emergency fund,
however, making money on the dollars you’re setting aside is less important
than making sure the money is easy to access and not exposed to risk. That’s
because the cost of not being able to pay your bills or cover a surprise
expense is so high. At an annual rate
of 3%, inflation doesn’t come close to the 30%-300% in interest you’d pay to
your credit card company or a payday lender to cover a sudden expense without
your emergency fund. Instead of looking at it as losing money to inflation,
instead recognize it as saving yourself far more money by not having to take on
loans to cover expenses. Remember, there is a very, very high cost to being broke and when you don’t have an
emergency cushion or fund to cover surprise expenses or sudden job loss you risk
entering a cycle of poverty that could bankrupt you.
The verdict? Something like a high yield savings account is
the best bet for saving for emergencies. Online banks can often offer higher
interest rates because their costs are lower than other institutions which
minimizes what you lose to inflation, but presently expecting much more than 1%
at the most is pretty unrealistic. And that’s okay! Remember, the funds need to
be liquid and unexposed to risk; earning a return on them is less important
than that.
(Have other thoughts? Feel free to share your approach to
emergency fund savings in our comments section below).
What to do when you spend emergency savings
It’s all well and good to save up your emergency cushion/fund
and to know where to save that money.
But what do you do once you’ve spent a portion of your emergency savings? Save
it up again! When you encounter a period of time in which you need to spend
some of the emergency funds you’ve set aside, the first step before other
savings goals is refilling that fund.
It’s important that your emergency savings stay stocked up
at all times. You never know when you might have a surprise expense or
unexpectedly lose your job (it’s important to save up your emergency fund even
if you think you can’t lose your job! You absolutely can lose your job!), so if you experience a month in which you need
to access your emergency fund make sure to focus on topping it off the
following month. If you do lose your
job and need to rely on the fund to cover all of your expenses while you find
new employment, your first task with the new job will be filling up the fund
again.
Boringly beautiful
The reality of emergency funds is that they’re not
particularly sexy, but they are incredibly powerful. A properly funded
emergency account means never having to worry about surprise expenses or the
loss of a job, and that’s a powerful, powerful sense of relief. It’s no surprise
then that saving your emergency cushion is step number two in the 10 Step Plan,
and that fully funding your emergency fund is fifth. It’s the best career
decision you can make, it protects your marriage against divorce, and it
prevents you from being forced into the cycle of debt that comes from not
having enough money to pay your expenses at the end of a month.
Boring? Sure, but when it comes to financial security
nothing is more beautiful than the feeling of freedom that comes with a fully
stocked emergency fund.
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