Thursday, February 18, 2016

Behold the Power of a Fully Operational Emergency Fund

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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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