Foundational Financial Planning:
Establishing an Emergency Fund
When it comes to an emergency fund, most Americans have failed to save $1,000 or more as an emergency fund for unforeseen expenses, and I totally get it. I have been right there with most Americans living paycheck to paycheck for most of my life. I grew up living in poverty and witnessing my family accumulate a vast amount of debt just to survive and put food on the table, and to tell you the truth, I started making the same mistakes when I became a young adult making financial decisions for myself. Lucky for you, I made enough of those poor financial decisions in my past. And in doing so, I can now hopefully educate and help keep others from making the same mistakes I did, without having to learn the hard way for themselves.
Why Do I Need an Emergency Fund?
An emergency fund is a cash savings account set aside to pay for large or unexpected expenses that may occur for such things as medical expenses, home appliance repair or replacement, major automotive expenses, or home repairs. An emergency fund can also help to bridge the gap when there is a loss of income due to being laid off, fired, or a market downturn.
Why Do I Need an Emergency Fund?
An emergency fund is a financial safeguard to help keep you afloat without putting yourself into debt by burying yourself in a heap of credit card and high-interest debt that will take years to climb out of. An emergency fund can also help give you time to make proper financial decisions without pressuring you to act quickly, to give you the runway needed to quit your job and start your own business, or the opportunity to search for the career you’ve always dreamed of.
How Much Should I Save?
The answer to this question differs by which stage of life you are in.
High School/College Student
As a student still living as a dependent of your parents, start with an emergency fund of $500 or $1,000 with the goal being to cover the cost or deductible of any item that got lost or damaged such as a phone, computer, or car.
High Interest Debt
It is still important for a person with high interest debt to create an emergency fund. Again, start with a small emergency fund of $1,000 to help keep you from accumulating even more debt and taking on high interest private loans or predatory loans such as payday loans. The goal here is to not only have a rainy-day fund, but to also focus on adjusting your budget and using your additional cash flow to pay off your high interest debt.
Single-Income vs Dual Income
Once you are debt free, it’s time to whip out your budget again and determine what your monthly expenses are currently and what your expenses would be if you were to no longer earn an income. If you are single, or a sole income provider, and lose your job, the typical rule of thumb is to save enough cash in an emergency fund to cover 6 months of expenses while you look for a new job. For a dual income household, the typical rule of thumb is 3 months, but if you make significantly more income than the other person in your household, have high household expenses, or have a job with high turnover or a lack of job openings, I typically recommend shooting closer to the 6-month range. This gives you more of a runway to pick the job you want and is the right fit rather than a job out of necessity.
Once you’ve made the decision to retire, the goal here is to have enough cash to cover your expenses for 12 to 18 months to weather any storm that may occur within the stock market. This is so that you’re not put in a situation where you need to withdraw money from your portfolio at higher rate while your investments are at a loss for the year. Having income sources in addition to cash, such as Social Security and Pensions, can also help insulate and protect your investments from market risk which in turn can lower the amount needed for you to save in cash.
Should I Pay Off Debt First or Create an Emergency Fund?
Again, start with a small emergency fund of around $1,000 to cover most deductibles and unexpected expenses to keep from going further in debt should those expenses arise. Then, focus all discretionary cash flow on paying off any high interest debt over 10%. You can choose the snowball method (smallest balance paid first) or the avalanche method (largest interest rate paid first) to get started and every time a balance is paid off you roll the payment into the next debt balance and so on until all your high interest debt is paid off.
Where Should I Keep My Emergency Fund?
The purpose of an emergency fund is to be readily accessible when you need it. Which means you don’t want it to be subject to market volatility, liquidity issues, or withdrawal fees. For that reason, a high yield savings account or a money market account will provide you with easy access to your money and provide you with some sort of interest rate that is often higher than rates you will find at your more local traditional banks. Once you have achieved your desired emergency fund and paid off your high interest debt, the next step would be to increase your savings to other accounts such as your employer provided retirement account (401k, 403b, etc.), Health Savings Account (HSA), IRAs (Roth or Traditional), or a taxable brokerage account.