Why an emergency fund should be part of your financial plan.
Hi Everyone! Welcome back to Melissa Making Cents!
Does anyone else remember the tale of the squirrel and the grasshopper? The condensed version says the grasshopper thinks the squirrel is foolish for hoarding away food and building its shelter for winter. When winter comes, take a guess who comes knocking on the squirrel's door. That's right, the grasshopper. We know that bad times (or winter) happen on occasion. We're not always expecting to get our gallbladder out or lose a job when it happens, and it helps to have some savings (acorns) for when it does. The savings I'm talking about is called an emergency fund.
The importance of having an emergency fund can't be overstated, and if you're sort of hanging your future self out to dry if you don't have one. Everyone knows that they should be putting money back for a rainy day - it's just intuitive. With that, however, comes a lot more unanswered questions: "How do I start an Emergency Fund?" "Where does a CERTIFIED FINANCIAL PLANNER™ fit in?". "How do I balance paying off debt and saving for the future?" All of this can be stressful at first; I totally understand that if you're coming to the realization that you should have an emergency fund but don't have one, that in-between time can be stressful. It also means that you may have to live a little leaner while you're setting up your emergency savings fund.
If the idea of an emergency fund or starting an emergency fund is totally out of your wheelhouse, don't worry! We're going to start from the ground up and give everyone the knowledge they need to successfully plan out and create their own emergency savings.
What is an Emergency Fund?
Basically, an emergency fund is a savings account that you only use in the case of an emergency. You don't touch it when you don't need it, so it's there when you do. At its best, an emergency fund is there to cover your bills and necessary expenses should you become unemployed or is there to pay for large unexpected bills (like trips to the hospital).
What is an Emergency Fund NOT for?
In short, an emergency fund is not for anything other than those two things. It's there to save you when you need it; it's not there to dip into when you have your eye on a shiny new car.
When You'd Need an Emergency Fund:
Let's quickly cover some of the incidents that would cause you to NEED to dip into your emergency fund.
- Car Accident
If you're in a car accident and insurance doesn't cover some amount of your new car or the repairs to an existing vehicle, you're not going to want to bleed your savings dry or dip into credit.
- Losing Your Job
Losing your job is never great, but what's worse is that it can leave you high and dry when it comes to your bills. If you're single and have a thin support system, you can see the importance of having emergency savings, but what's more important is if you have a family. With an emergency fund, you can put back money to cover school, medical, and food expenses for your spouse and or children.
Medical expenses (especially large ones) are never wanted or expected, but they do happen. If you went to the emergency room today and your insurance didn't cover most of it, would you be okay? If not, you need an emergency fund. Remember, no one plans an ER visit.
- Economic Downturn
In the wake of coronavirus and remembering the 2008 recession, we should all be very self-protective of economic downturns. We've seen it happen in the past, and it's not fun. People lose their long-time jobs, new jobs aren't being created, and inflation is rampant. Having an emergency fund is one way of shielding yourself against a recession or depression should it happen.
Having An Emergency Fund Is A Way to Avoid Credit
One of the best reasons to have an emergency fund is that it'll allow you to avoid putting too much money on credit cards. Credit cards come with interest, and you'll end up paying more money on your emergency purchases than you would if you were to have put it aside ahead of time. Credit cards are useful as a complete last resort option, but you should never rely on them - they can't replace an emergency fund.
Is an Emergency Fund the Same as a Savings Account?
While you may opt to keep your emergency fund in a savings account, you should make no mistake - they are not the same thing. An emergency fund is there only to save you in… an emergency.
So, what are savings accounts?
Well, for starters, a savings account is a specific kind of account that you keep with a bank. Banks let you store your saved money in an account; in return, you allow them to invest that money and give you a tiny piece of the return on their investments.
Less formally, a savings account is an account that you use to save up for larger purchases. If you're interested in saving up for a down payment or buying a car outright, they give you a place to keep your money until you've hit your goal. Savings accounts are great and should be encouraged, but they differ from an emergency fund in that they're there to meet goals and use as opposed to an emergency fund that's there to hit a goal and hope you never have to use.
How Long Should an Emergency Fund Be Able to Last?
This depends on the person and how much protection they want, but I recommend having an emergency fund that can last you between eight and twelve months. It would help if you planned for your emergency fund to cover you long-term in case whatever emergency you encounter means you'd have to search for and find a new job. Anyone who's been on the job hunt before can tell you that it's a scary time. You're not sure if or when you'll ever hear back from someone, and when you finally hear back, you still have to go through the interview and hiring process. It can take quite a while.
If you're a real go-getter, eight to twelve months is a fantastic amount of time to be covered. Having an emergency fund that's able to cover your cost of living, bills, and expenses for almost a year to a year gives you enough wiggle room so that you won't have to settle if you're looking for a new job.
Pretend that you're looking around all you can, but either nothing is biting, or there aren't any jobs opening up that fit your career path. Having an emergency savings/emergency fund that can cover such an extended amount of time will give you a lot of flexibility should you find yourself under-employed. What does it mean to be under-employed? It means that you're a highly-skilled individual working a lower-skilled job (Ex: a doctor working at Wendy's).
How Much Should be in my Emergency Fund?
How much someone needs in their emergency fund is also partially left up to the fund holder. The financial planner part of my brain says you should have however much you need to pay your bills and live for about eight to twelve months. That specific amount varies from person to person, but you should exclude anything that isn't necessary (like Netflix or whatever subscription box service you're currently into). Focus on the necessities; you need enough food, water, power, car note, rent/mortgage payments, insurance, etc.
There are great tools out there for calculating this; there are also apps that you can use to track your bills. As a rule of thumb, you could take an average of your monthly bills and spending over the span of a year, divide it by twelve; you can then multiply that number by however many months you'd like your emergency fund to cover (8-12).
I would highly suggest contacting me or another CERTIFIED FINANCIAL PLANNER™ who can help you plan your emergency savings out strategically and intelligently!
What Is Liquid Savings Versus Non-Liquid Savings:
While it's great to have investments, whether that be a car, house, stock, or anything else, you shouldn't count them toward your emergency fund. Your emergency fund should be liquid and ready to go. If you're in the midst of an emergency, the last thing you want to be doing is putting your house or car up for sale. The point of an emergency fund is to give yourself as much wiggle room with as little struggle as possible. Putting a house up for sale will absolutely give you some money, but it'll be a drawn-out process to get it. While more manageable, selling a car is also a hassle you don't want to or won't be able to deal with in the case of a real emergency.
Suppose the economy is down, and that's one of the sources of your financial difficulties during an emergency. In that case, you're going to have a difficult time selling anything. If you are successful in selling whatever you're trying to liquidate, you may be forced into selling it for pennies on the dollar. And... let's not forget the possibility of paying taxes or capital gains on the asset that you sold!
Stage Savings into Financial Buckets
Buckets are an incredibly useful tool that you can use to budget. Having multiple "buckets" means that you're looking at different incidents and keeping separate pools of money related to each one. Staging your emergency fund into buckets means that you're going to be able to plan out your bills effectively and strategically, which will give you a much more accurate number than guesswork.
Here are some examples of buckets that you might use to plan out your emergency fund:
- Personal Expenses
This bucket could be used to plan out your finances for eight to twelve months. You know that you'll need gas, food, shelter, and insurance - so you'll be able to account for all of that.
- Business Expenses
If you're a business owner, you can create a business expenses bucket to plan out whatever business bills or costs will happen over those eight to twelve months.
Having children, dependent spouses, or dependent parents will also widen the amount of money you're going to have to save. If you have dependents, you're going to want to keep track of their expenses and work them into an eight to twelve-month plan as well.
Resist Temptation to Dig in For Big Purchases.
The very last thing you want to do with an emergency fund is to dip into it to cover large purchases. That's what savings accounts are for. It doesn't do you any good to have an emergency fund if you're constantly refilling it. Ideally, you want to get your emergency fund where it needs to be and keep it there (adjusting from time to time if your expenses increase).
Having a nice emergency fund is not an excuse to go out and make a big purchase or make a down payment on a house or car.
Start Small And Build Your Emergency Fund Over Time
The critical thing to remember is that Rome wasn't built in a day.
Everyone starts small, you're not going to fill your emergency fund overnight, and you shouldn't let that frustrate you. After you decide how much longer you're planning on saving for and how much you'll need, you can plan how much you can contribute monthly to your fund. A good goal is to set aside a percentage of each paycheck to contribute and let that build up to your goal amount over time.
Growing your Savings over time is what it most important!
A CERTIFIED FINANCIAL PLANNER™ Can Help You Develop a Plan to Create an Emergency Fund
If there's any big takeaway here, it is that you should absolutely be working towards setting up an emergency fund and regularly contributing to it.
CERTIFIED FINANCIAL PLANNERs™ and financial advisor representatives, like myself, can help you plan and create a plan to get your fund up and running. Contributing a small amount of your paycheck to an emergency fund will create a more secure future for yourself and anyone who depends on you. Another essential thing to remember is that an emergency fund is not a savings account. You're not building it only to squander it when that next flashy thing comes out. It's a smart way to protect yourself against unforeseen expenses or job loss. As a CERTIFIED FINANCIAL PLANNER™, I've worked with clients to create plans and establish emergency funds and savings. If you or a family member need some guidance in building your emergency fund, please call or email to schedule an appointment with me.
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.