Emergency Funds: Are you ready for a rainy day?
Last week it was reported that the US economy added 250,000 jobs and the unemployment rate held steady near 3.7%. Unemployment claims continue to fall and are at levels not seen since 1973.
A lot can happen in 10 years, can’t it? Look at this chart of the unemployment rate since 1970.
Emergency Funds: The first line of defense against economic uncertainty
An emergency fund is one of the cornerstones of sound personal finance. Emergency funds are like the shock absorbers in your car that cushion the blow from all those Chicago winter potholes. Does the car need a new $2,000 transmission? “No problem, we already have funds set aside for that.” Furnace didn’t start on that first 30-degree night in October? No problem.
Using the pothole analogy above, you can imagine how it feels when you don’t have emergency funds set aside. That $2,000 transmission repair ends up on some credit card charging you 18% interest each year. Before long, a couple of “emergencies” have you deep in debt and unable to get out of the hole. What could have been a smooth ride has now turned into bumpy, uncomfortable
They’re not just for one-off emergencies
Going back to that chart of the unemployment rate, you can see the economy goes through cycles. In fact, there have been six recessions since I was born in 1974. In each of those recessions, the unemployment rate went up – sometimes a lot.
When you’re dealing with broken transmissions and furnaces it’s nice to have emergency funds set aside. But these funds can be a lifesaver in a real emergency – a lost job. It’s one thing to have an unexpected expense pop up. It’s an entirely different thing when you’re no longer getting your bi-weekly paycheck.
Losing a job and not having any emergency funds to fall back on can be a traumatic experience. Your immediate thoughts race to:
- “How am I going to pay the mortgage?”
- “How are we going to pay for our cell phone service?”
- “How long can we skip the electric bill before they shut off the lights?”
Emergency funds help you avoid that initial sense of panic when a job is lost. If you don’t have an emergency savings fund, let me encourage you to get build one.
Remember, the economy is great now. But that can change, as you see in the chart above. Don’t wait. Start putting those emergency funds aside right now. I’ll show you how right now.
Emergency Fund Rule of Thumb
Pundits will say that you should have 3 to 6 months worth of expenses stashed away as an emergency fund. That’s not a bad rule but leaves too many unanswered questions. Should you have 3 months stashed away or 6? Something in between? What expenses should you be saving for in the emergency fund?
The answers to these questions depend on your unique circumstances. That’s why I’m not a huge fan of parroting rules of thumb. Instead, let’s break the issue down to its two main parts:
- Number of months you should have stashed away
- Monthly living expenses you would need to cover
Solving these two questions will point to the dollar amount that should be in our Emergency Fund:
Emergency Fund Amount = # of Months Needed x Monthly Living Expenses
Emergency Fund: How Many Months?
Determining the exact number of months of living expenses you should have stashed away is more an art than a science. A lot depends on your own emotional risk tolerance.
The best way I know to bring some “science” into the process is to look at your job situation. Here are some questions to ask yourself:
- “If I lose my job tomorrow, how quickly can I get another job?”
- “If I’m able to find a new job, will my pay be the same? Better? Worse?”
Depending on what you do for a living, it may be easy or hard to get another job if you lose the one you have right now. For example, if you work in Information Technology and have a skill set that’s in demand, you might be able to find a new job quickly. In that case, you might be able to get away with having 3 months of emergency funds saved up.
But if you work in a struggling industry, are highly-paid, or have a specialized skill set, you may find it takes a lot longer to find a new and similar job. It could take six months or even up to a year, in some cases.
Look around today at the job opportunities that are out there. Are there tons of opportunities in your industry? If so, then 3 months of emergency savings might suffice. But what if there’s not a lot out there? Or what if it would take several months of sending resumes and interviewing to find new work? In that case, you might want to save up at least 6 months of expenses – or more.
Once you have a sense for how quickly you could get a new job, you have to check your risk tolerance. If you’re risk-averse, it might be worth adding a couple extra months of savings to be on the safe side. The goal is to have funds in place that you can use between the time you lose a job and find a new one.
Emergency Fund: What are my living expenses?
The second part of the emergency fund equation is straightforward. How much do you need to live on each month? If you have a monthly budget and a good handle your monthly living expenses, you’ll likely know.
But if you’re like most people and don’t have a monthly budget in place, you’ll have to do a little work.
The goal you’re trying to achieve is taking care of your basic necessities. You have to imagine yourself without a job and income. What are the essential bills you would have to pay to stay afloat? There are four basic monthly necessities I’d like you to zero-in on:
- Food – Cost of groceries
- Shelter – Mortgage/rent, homeowners insurance, electricity, gas, water, real estate taxes
- Transportation – Monthly car payment, insurance, gas, maintenance
- Clothing – Do you have young children? You’ll need clothes!
Figure out what these monthly costs are and you’ll have a good idea of the bare minimum your family needs to live on. You don’t see restaurant expenses, vacations, or new power tools here. Those are discretionary expenses. Meaning, you can live without them in an emergency.
If you have debt beyond a mortgage and car payment it gets more complicated. Having debt when you’re unemployed magnifies the stress you’d otherwise be feeling. Make it a priority to get out of debt. If you want, you can factor debt minimum payments into your monthly ‘necessities’ and save for them as well.
And your emergency fund total is…
Now take your monthly living expense number and multiply it by the number of months you may need to carry you through an emergency. This is how big your emergency fund should be.
You may be looking at this number and thinking there’s no way you can scrape up this kind of cash. If you live paycheck-to-paycheck, you’ll no doubt have this feeling. But let me sell you again on the benefits of having an emergency fund. If/when you lose income, you want to avoid:
- Worrying about how you’re going to put food on the table
- Panicking and putting everything on credit cards, making a bad situation worse
- Looking out the window hoping the car repo man didn’t pay you a visit in the middle of the night
Another benefit? You’ll have time to find the right job instead of taking whatever offer comes along and getting stuck in a crappy company.
Emergency funds buy you time. Time to calm down and make rational decisions.
Tips as you build your emergency fund
Tip #1: If you don’t have extra cash laying around to set aside in an emergency fund, you need to create a savings plan. This depends on your monthly cash flow. If you don’t have any debt (other than mortgage) then I would suggest trying to have it fully funded within a year. Be as aggressive as you can. The idea here is to get your emergency fund saved up as quickly as possible.
For those of you that have debt, I’d suggest building up an emergency fund to cover one month of living expenses. Once you do that, get on a plan to get rid of that debt! You don’t need it and it’s only going to cause you stress if the economy turns south. After you pay the debt off, come back and finish building the emergency fund.
Tip #2: Open a dedicated savings account to store your emergency funds. Keep these funds separate from everything else you do with your money. They’re not for taking quick vacations or buying a new iPhone. They’re for emergencies only.
Internet banking has progressed to the point where you can get an account set up and funded in a couple of days. Online banking platforms tend to pay better interest rates than you get at the bank branch. In fact, you can get close to 2.00% interest at many online banks today (11/7/18). That’s a heck of a lot better than what most traditional banks are paying.
Tip #3: Don’t get cute with your emergency funds. Don’t buy Certificates of Deposit (CDs) with your emergency funds. Your emergency funds need to be liquid and accessible at a moment’s notice. CDs will lock you in for several months or even a couple of years.
Also, don’t fall in the trap of thinking “Well I can invest these funds in the stock market and make more than 2%!” You might, but you also might end up losing money. Think of your emergency fund like you do car insurance. You pay for car insurance each month hoping you don’t need it but glad you have it in case you get into an accident.
Time is of the essence. The economy is good. Jobs are plentiful and wages are going up. If you don’t have emergency funds set aside, NOW is the time to get after it.
Follow the plan I’ve laid out to determine how much your emergency savings should be. When you have emergency funds in place you’ll feel a sense of peace and accomplishment that your family is prepared to face rainy days. History says the rainy day will come. Do your best to prepare for it!
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