What would you do if your refrigerator stopped working without warning, if you had to replace the transmission on your car, or if you had to replace your cell phone? While I hope no one is ever put in these types of situations, the purpose of the question is to get you thinking. In life, things happen. There are certain situations that are just outside of your control. This has become very apparent in 2020 as the coronavirus pandemic has upended the lives of countless families and the outlooks of numerous businesses. Whether it’s a fridge dying, the loss of a job, or a medical emergency, do you have a plan in case something goes awry? Since there are an unlimited number of scenarios, it’s nearly impossible to plan for every contingency. Thankfully, I don’t think it’s necessary to plan for every single possibility. Setting up an emergency fund is a critical component of personal financial planning that can prepare you for a multitude of unforeseen events.
What Is an Emergency Fund?
In a general sense, an emergency fund is an amount of money that is easily accessible in case an unexpected situation arises. Not only does an emergency fund provide unparalleled peace of mind, it can be the difference between financial ruin and being able to make it through a difficult time. On one’s journey for financial freedom, building up an emergency fund and paying down high-interest debts should be some of the first items on the to-do list.
Building Your Emergency Fund
A car accident or medical emergency can stop one’s progress toward paying down debt in its tracks. It can stall momentum and be incredibly hard to come back from. There are many recommendations regarding the timing of building an emergency fund. Some experts suggest doing it as the first step of the financial freedom journey and others recommend building an emergency fund after paying off high-interest consumer debts (credit cards, personal loans, etc.). I certainly think that there is merit to both approaches. Because no one can see into the future, there is no outright correct answer. It simply comes down to personal preference.
If you’re more conservative or if you tend to worry, you might opt to build an emergency fund before paying off your high-interest debts. In your mind, knowing that you are prepared for an unfortunate incident might be more than worth the forgone interest savings from paying down some debts.
If you tend to be a more risk-tolerant (meaning able to tolerate risk), you might prefer to first pay down your high-interest debts before building your emergency fund. By handling it in this order, you essentially lock-in interest savings by paying off those debts first. If you want to take this approach, make sure you are comfortable and able to put the cost of an emergency on a credit card should one rear its head. Without an emergency fund, this is practically the only way you’d be able to weather an emergency situation.
From a purely numbers perspective, the greatest amount of interest savings is realized when you pay off the high-interest debt before building an emergency fund. However, the mental and emotional toll of having to put a several thousand-dollar expense on a credit card and the ensuing stress about paying it off might just be too much for you. If you desire, you can even pay off high-interest consumer debt and build an emergency fund at the same time, it’s your choice!
I don’t think it makes sense to do it one way or the other just because you heard an expert say so on TV or because the author of the book you’re reading suggests it. They aren’t the ones that are going to have to deal with the consequences of the decision. You are, so do what makes you feel more comfortable.
How Large of an Emergency Fund Do I Need?
Once you’ve decided whether you want to build your emergency fund first or pay off high-interest debts first (or do them simultaneously), the next step is to determine the size of your emergency fund. Again, deciding on the size of the fund is also not an exact science. Generally, the size of an emergency fund is based on the living expenses of a family or individual. If you have a budget (I hope you do), you should be able to easily figure out a total for your monthly living expenses. If you don’t have a budget, take a look at this previous blog post for information about creating one for your situation. Basing an emergency fund on monthly living expenses is a popular approach since one of the most unfortunate circumstances that people can plan for is the loss of a job where monthly income essentially goes to zero. In the case of a job loss, having an emergency fund that covers living expenses long enough to find new employment is essential. When looking for a new job, the last items people want to think about is how they are going to make their rent/mortgage payments or put food on the table. If you do get laid-off, having the resources to complete a thorough job search and find a position that pleases you is an invaluable asset.
As a general guideline, most material will recommend using three to six months of living expenses as a good gauge for the size of an emergency fund. The range varies widely because everyone’s situation is different. Some people may feel comfortable with a fund that only covers two months of their living expenses and others might only feel comfortable when their emergency fund can sustain them for an entire year. For example, if you are in a high-demand field with a specialized skill set and years of experience, chances are you would be able to find a job relatively quickly. Compared to a person that has recently entered the workforce in a low-skilled position or saturated market, you would probably not need as large of an emergency fund.
Where Should You Keep Your Emergency Fund?
It most likely wouldn’t be prudent to invest the money earmarked for emergencies into a risky asset of any kind. The entire concept is for the money to be there when you need it, not to put it at risk for the opportunity of growth. It’s important to make sure that the money is easily accessible too. I’m a proponent for keeping an emergency fund in a savings account that is FDIC-insured (for banks) or NCUA-insured (for credit unions). Each of these insurances provides protection for up to $250,000. Savings accounts are also easily accessible and most of them pay a small amount of interest on the account balance.
Our Emergency Fund Situation
I’ll be honest with you, Nicole (my wife) and I have not done a good job at setting up an emergency fund. It’s probably the weakest aspect of our financial plan. So far, we have been fortunate enough to not have needed one. However, we recognize that being hopeful is not an appropriate planning strategy. In the next month, our goals are to identify how large of a fund we need and to set a suitable amount of money aside in case we do encounter an emergency. Even though we aren’t too keen about the possibility of our money slowly losing its purchasing power because of inflation, we would much rather be prepared for the unexpected circumstances life might send our way.
If it sounds like the information about timing and size of your emergency fund is a bit vague, know that it’s meant to be. Everyone’s situation is different. There is not a “one size fits all” approach when it comes to personal finance. Since no one knows you better than you do, it’s up to you to figure out the specifics based on your comfort level and personalized situation.
If you are unsure where to start or struggling to determine how large your emergency fund should be, please use the Your Thoughts page to reach out.
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