What is an emergency fund and how can you build one that will work for you if you have an emergency?
Get out of debt first
First things first, don’t build an emergency fund while you have debt. I think of it like this, if you want to fill a bucket with life sustaining water, you first have to plug the holes in the bottom of the bucket. Debt is a bucket with holes in the bottom, the only way to plug the holes is to stop using your credit cards or open ended loans, and then pay off your debt. Once the holes are plugged and your debt is paid off your bucket will overflow.
What would Warren do?
I think it was the billionaire Warren Buffet who said he does not know of an investment that will pay 18-20% returns. When you have credit card debt, you are paying 18-20% returns to the credit card company. Figure out first how to eliminate your debt, and then build your emergency fund.
When planning an emergency fund consider how much you truly need. I like to have about three to six months of expenses set aside. I set aside this money in a diversified investment account. I don’t keep money in a savings account. After all I may never have an emergency, and my fund must earn while I’m storing it for a rainy day. I may never have an emergency, but my money should always be working for me.
Make sure you are limiting your tax burden
Before you begin saving for a rainy day take time to understand your finances. You can take steps to reduce your tax burden that will have little impact on your take home pay. If your company offers a 401k option, that is fantastic, time to get out your calculator. Figure out how much you are taking home each pay period. Then figure out how much of your pay you can divert to a tax differed retirement account. The idea is that you can invest your earnings, possibly get a matching amount from your employer and see little difference in your take home pay. There are simple calculators on the web that can help you with this. If you are making just enough to get by, start with a small contribution that has the least impact on your take home and then adjust as you learn more about the impact of your contribution. Every company is different, I have worked for companies that allow you to change your contribution at will and others that allow changes once per year. Check with your human resource manager or look at your employee manual to understand what is allowed. Starting small is the safest way to manage your contributions especially if changes aren’t allowed at will.
Understand your absolutely necessary expenses
While you are figuring out your finances, remember that all the expenses you have today may not be essential expenses. Clearly you must pay your rent or mortgage. You must pay your insurance and utilities. But you don’t have to pay for expensive subscriptions, for example streaming services, health apps or self improvement apps, music subscriptions, audio book subscriptions and more. I suggest that if you are in an emergency that requires dipping into your emergency fund, all non essential expenses should be suspended until you are in better shape.
Now that you have a list of essential expenses, determine if there is a way to reduce this as much as possible. Get that bottom line all the way down to the bottom.
Pay yourself first
Once you have completed this task you should know how much you absolutely must have to survive. Begin adding to an investment fund each pay period with your disposable income. Remember to invest in yourself first. As a general rule I recommend waiting until after investing to determine if you have any leftover funds you can splurge on education to increase your value in the workplace, or other experiences that will add to your life or relationships. I like to keep a buffer amount set aside not invested that I can use for unexpected expenses. Little things come up each month, in fact if you look at your spending over the past few years you can estimate how much you will need for unexpected expenses. The amount will average out each year, even though the unexpected purchase will be different, it will almost always be predictable based on your past experiences.
If you need it, use it
Do this for a few months, a year or a few years and you’ll have a nice nest egg in addition to your retirement fund. Your emergency fund should remain untouched until you truly need it. Perhaps you’ll never have to tap into it.
Remember that if you are investing in a fund, it may take a few days to get access to your money. As well you may have to sell your funds at a time when the market isn’t working your favor. Don’t over worry about this, when you have an emergency and you have funds to help you that’s what’s important. Eventually you’ll build up your emergency fund again.
Consider the alternative
Consider the alternative. The alternative may be that you have no fund and have to count on expensive credit cards to cover your emergency. It could be you have no emergency fund and find yourself asking your cousin if you can crash on their couch. Maybe you have to go around with a few missing teeth because you can’t afford the dental work you need. Anything can happen and your emergency fund is there to get you out of a mess if one should come up.
Here are the most important things to remember when creating an emergency fund-
- Understand well your income and expenses.
- See if you can defer taxes and keep your take home income about the same. Your emergency could happen when you are retired and having a retirement investment account is important for a good experience after 65.
- Pay off all debt especially expensive credit cards before you build your emergency fund.
- Once you are out of debt, make sure to pay yourself first, either a specific dollar figure or a percentage of your take home pay.
- Make sure you set up an investment account for your emergency fund, don’t just stick your money in a savings account, it won’t earn much that way.
- When you find yourself in an emergency that requires tapping into your fund, make sure you also eliminate any unnecessary expenses as well. Make your emergency as short lived as possible.
You can learn more about managing your money and frugal living in my book, “Never Worry About Money Again: Gain Financial Freedom By Becoming Better At Managing The Money You Have”
