A Comprehensive Guide to Planning and Creating an Emergency Budget
Hi everyone, and welcome back to Melissa Making Cents!
As a CERTIFIED FINANCIAL PLANNER™ and financial coach, I can confidently say that if 2020 has taught us anything, it's that we should expect the unexpected. In times of hardship, budgeting and planning might be the last thing on your mind; you may act in the moment and choose to think about those actions later to stay afloat. Truthfully, while that feels like a good plan in our head, that isn't always the case. As a CERTIFIED FINANCIAL PLANNER™, I've collected some great information to help you create and stick to an emergency budget when the going gets rough. A huge part of personal finance is making sure that our lifestyle expectations match up with what's on paper. When we leave our finances and budgets entirely up to "feel," it's very likely that we're living past our means or spending recklessly. While there isn't any shame in having a good time now and again, it's far better to stick to a budget. By sticking to a budget, we're able to know how much we're spending on what and plan for occasional shopping sprees, nights out, or however else we like to indulge ourselves.
While planning an emergency budget may sound silly, especially in times of feast, when famine comes, they're invaluable to have. There's an exercise I like to do with my financial coaching clients. First, create a budget for yourself. Second, cut out anything that isn't utterly essential. I mean EVERYTHING that's not essential to your immediate wellbeing, food, shelter, etc. (…yes, that means cutting out Netflix and Hulu too). While it may feel like an over-kill to cut out anything and everything non-essential, it's a great tool to see how much you're spending on what you need as opposed to what you want.
Why You Need an Emergency Budget
Let's start with the basics… Why would you need an emergency budget? The question is as simple and straightforward as the answer. You need an emergency budget in case you ever truly need one. As I said above, it's too easy to fall back on instinct in times of crisis. By creating an emergency budget, you're not allowing yourself to fall back on instinct because you already have a plan in place.
In case you were wondering, that instinct I'm referring to has a lot to do with relying on your credit cards. In times of need, it is common for us to not to want to change our habits or lifestyles. Instead we rely on credit cards to get us through the rough patch, which in turn can create a financial nightmare. Our goal is to break our dependence on using credit cards as a financial plan, and shift to a solution that will allow us to maintain healthy finances.
In a more concrete sense, you might need an emergency budget if you were to ever lose your income. Losing a job can be challenging; getting fired or laid off is an incredibly difficult hardship to deal with. In an instance like this, you're better off having an emergency budget that will allow you to take your mind off of your finances and will enable you to put one hundred percent of your focus on finding your next job or client. Another reason you may need an emergency budget is in the case of a major medical incident. A fact of life is that we occasionally get sick or hurt. If, for you, that were to mean not being able to work, having an emergency budget to restrict your spending will help you have as much time as you need to get back on your feet. Another less thought reason one may need an emergency budget is in the unfortunate case of losing a loved one. If you're grieving the loss of someone you love, finances shouldn't be yet another concern to add to the pile.
There are plenty of other reasons that you may need an emergency budget, but those I've listed are common occurrences that happen to all of us at some point or another. Dealing with losing a job/loved one or a medical situation can make life infinitely more complicated. One way to make times of hardship easier for you and your family is by creating an emergency budget ahead of time that you're able to fall back on.
Step 1 - Get to Know Your "Regular Budget"
Being familiar with your "regular" budget is the first step to creating an emergency budget. Creating a budget of what our income and expenses are when times are going well can help us understand our financial situation by assessing how much we're spending on what and if we must be doing so. If you need help creating a regular budget for you and your family, speaking with a financial professional or financial planner may be a logical first step. If you feel that you're able to do this on your own, here's a fantastic article by Nerdwallet that's compiled a few different types of budgets on various platforms like Microsoft, Google, and Mint.
Start by finding out what your monthly income is; if you're married or share finances with another person, find out theirs too. This should give you a solid idea of how much money you're bringing in each month. Be sure to include any and all income, including things like social security, child support, and money from your paychecks. Next, list out all of your fixed expenses. These expenses rarely fluctuate or change (these should include all insurance, rent/mortgage, car payments, etc.). After that, compile a list of your flexible expenses that may change month to month but are still necessary. After that, it's time to add up your non-essential expenses. Make sure that you have each number separated, and that's the breakdown of your budget. Once you have your breakdown, you can add all of your expenses together and have two numbers: total income and total costs. Subtract your expenses from your income and see what you're left with.
Step 2 - Strip Your Budget of Non-Essential Expenses
Should an emergency arise, you'll want to be spending as little money as necessary, so you're able to hold onto your emergency fund for as long as possible. After you've created your regular budget, it's time to start taking a hard look at where your income is going, why it's going there, and if it's essential or not. While there are varying degrees of emergency, you should aim to cut out anything non-essential. This means looking at your flexible and non-essential expenses and analyzing whether or not they're going to make the cut. This can be an arduous task to take on alone, and many feel they need help when deciding what to cut and what not to cut when it comes to their emergency budget. If you didn't in step one, it's time to bring a financial professional aboard to help you sort out your expenses.
In an emergency, it's imperative to work to reduce spending in any way possible. You want to keep as much money flowing towards the essentials as possible for as long as possible. That's why not only should you cut out things that you don't need, but you should also work on lowering the amount of money you're spending on the things that you do need. While it's essential to stay healthy, this means looking at how you can cut down the amount of money you're spending on things like food, gym memberships, and clothes. Though reducing costs can be as tricky as cutting them, options like coupons, store memberships, and bargain hunting offer helping hands.
The Difference Between an Emergency Budget and Emergency Fund
Though many confuse the two, emergency funds and emergency budgets are two separate things. They work very well together, but they shouldn't be mistaken for one another. In my article Why an Emergency Fund Should be Part of Your Financial Plan, I discuss what an emergency fund is, why it's crucial to have, and how to create one. If you're interested in creating an emergency fund, I highly suggest reading that article as it contains some great information. In short, an emergency fund is money that you've set aside should an emergency arise. An emergency budget is planning how much money you'll use for what ahead of an emergency.
An emergency budget and an emergency fund work best when coordinated, and having both will help you more than having one or the other in the case of an emergency.
Assets are good, but emergency funds need to be liquid. Even though having various assets is a fantastic thing, the money in your emergency fund needs to be liquid. In the case of an emergency, you don't want to be caught up trying to sell your house, car, stocks, or bonds. (You risk the markets being in a correction, and tax consequences for selling assets) You'll want to have money set aside in an account ready to go. One excellent method is to keep money set aside in a savings account in case of an emergency that you regularly contribute to but don't withdraw from regularly.
Pitch In and Save While Times are Good
While in an emergency, it wouldn't be a bad time to save all of the extra income you have (if you have any), it's not the ideal time to start your emergency fund. When times are good, you should have a minimum amount to put back towards your emergency fund. Cutting back as little as $25 per week can make a massive difference in the grand scheme of things, and it'll add up over time, making your small contribution grow larger and larger in your account. Setting a minimum amount for yourself to save is important; however, when there's no emergency, and there's money to spare, it's never a bad idea to set aside extra instead of spending it.
Create a New Account. The best option you have for your emergency fund is to create a new account to keep that money separated from your main account. Having multiple accounts and putting money aside for different things in each is called creating buckets. It's a fantastic budgeting tool that will help you keep your hands off your emergency fund and save and plan for future expenses. You can read here about creating budgets in an article I wrote, How Buckets Fit into Your Financial Plan.
Communicate Your Budget with Your Family
Communication is key. It's also a great way to involve everyone in what's going on. While I wouldn't necessarily recommend bringing your kids in when times are too rough and stressing them out (that needs to be done with tact), I would recommend getting your spouse and kids in when planning a budget. It's a great way to educate your children and loved ones about the importance of planning your finances effectively and saving money for the future. It's never too early to start instilling great monetary habits into young people. Keeping your children in the loop will also help them understand why they can't have that PlayStation 5 right this second and could help bring everyone closer together as a family.
Do Your Best not to Rack Up Debt (Especially on Credit Cards)
Creating and sticking to your emergency budget will help you avoid racking up debt. Sometimes, you have to do what you have to do during an emergency, and debt is, unfortunately, sometimes a part of that. Creating your budget ahead of time and having a plan in place should anything go awry will play a role in helping keep you away from tempting credit cards, which come with high-interest rates and can take extended amounts of time to pay off. If you're struggling with credit card debt, or any other kind of debt, talking to a CERTIFIED FINANCIAL PLANNER™ like myself can help you find options to get out of debt faster and be your first step on the path to financial planning success!
A CERTIFIED FINANCIAL PLANNER™ Can Help You Create a Plan to Prepare for Emergencies
Another word on debt and emergencies - If you have debt, credit card, or otherwise, there's never a better time than the present to start getting out of it. When you find yourself in the middle of an emergency, obviously isn't the time you want to start thinking about how much debt you have and how much interest you're paying. If you start working on your debt when times are good, that's yet again one less thing you'll have to worry about should an emergency arise.
Do you want to create an emergency budget or emergency fund? If you need guidance when creating a budget or talking through necessary and non-essential expenses, or if you'd like help paying off debt, please call or email to schedule an appointment with me. I'll work with you to create a financial plan that's optimized for you.
Until next time...this is Melissa Making Cents!
Melissa Anne Cox CERTIFIED FINANCIAL PLANNER™ is also a College Planning and Student Loan Advisor and Financial Coach in Dallas, Texas.