When it rains, it pours. Murphy's Law reigns supreme. Stuff happens.
As much as we may try, we just can't avoid the fact that bad things will happen to us, often at the least convenient time. But, what we can do is prepare ourselves for the inevitable. So, how exactly do we do that?
The emergency fund. The rainy day fund. The money under the mattress.
An emergency fund should be money that's available to you in case the storm clouds roll in. Let's take a look at some of the ways that Murphy's Law can hit you when you're down:
Reasons for an Emergency Fund:
First, it's important that we define an 'emergency." An emergency is not a big sale at Target. An emergency is not a deal on a classic car that you found online. An emergency is something that pops up unexpectedly that has a significant negative impact on you and your life.
1. Job Loss
A loss of income is by far the #1 reason that we all need to have an emergency fund. If you work in corporate America, you know how ruthless it can be. Your company's stock drops by 5% and the executives get greedy, panic, and lay off 20% of the workforce (and then hire them back a year later at a lower salary, but that's another discussion for another day).
Wouldn't it be nice to have a backup in place so that you aren't the one panicking about paying the mortgage while you're out job searching? Trust me, employers can smell desperation - it doesn't help your chances of getting the job you want, the salary you want, or the vacation package you want.
2. Medical Bills
The American healthcare system is an absolute train wreck. I could go on for days about that problem, but we're here to help, not to complain. At a former job, I had health insurance and went to an in-network provider, but I still got a $180 bill every time I went to the doctor. One of my medications costs me upwards of $400 per month because insurance won't cover it. Plenty of other Americans have it WAY worse than I do.
Medical bills are quickly becoming one of the top reasons people are filing for bankruptcy. A nice cash cushion can help you ride out unexpected medical bills and any missed work due to health issues. Also, don't forget that most healthcare providers offer reasonable (and oftentimes no-interest) payment plans for larger bills.
3. Auto Repairs
I recently had lunch with a friend that told me about his engine blowing up on the Interstate. His car only had 52,000 miles on it. Guess how long the warranty covered the car? 50,000 miles.
The dealer wouldn't help, and the manufacturer offered a $1,000 rebate on the purchase of a new car. What a slap in the face! Nobody wanted to buy the car with a blown engine, so he had little choice but to replace it. A multiple-thousand dollar bill, plus a rental car while his car was in the shop.
Thankfully, he had the emergency funds to cover the expenses. But imagine if he didn't...
4. Home Repairs
Home ownership - the true American Dream, right? Plenty of natural light, a white picket fence, 2.5 kids and a dog playing fetch with you in the back yard. Beautiful, isn't it?
It's not quite as beautiful when your air conditioner dies in the middle of a heat wave in July. It's a nightmare when the sewer line backs up all the way out to the road.
But, the pain is much less when you have the cash available to cover these unexpected disasters.
Where Should I Keep My Emergency Fund?
A topic that's always up for debate: where should I keep my emergency fund? Which type of account is best? For retirement and other long-term savings, your earnings/interest rate are very important. For your emergency fund, it's more about ease of access. Sure, it's nice to earn some cash on your emergency fund, but not at the risk of giving up access.
1. Savings/Money Market Account
A savings or money market account linked directly to your checking account at your bank is the most simple option, and oftentimes the most simple option is the best option. You're not going to become Jeff Bezos by earning interest, but you will have almost immediate access to your money should the storm clouds arrive. Online high-yield savings accounts are fine, but beware that it may take 1-3 days for your money to transfer over to your checking account.
2. Brokerage/Investment Money Market Account
Some people like to keep their emergency funds in a money market fund inside of their investment account. While these funds may be attractive due to their generally higher rates, keep in mind that it will take a day or two to transfer funds to your checking account in most cases.
3. Cash
I feel strongly that having your entire emergency fund in cash is not a good idea. I can get behind keeping a small cash reserve (less than $1000) in a safe place, but the risks of keeping large amounts of cash outweigh the benefits tenfold. Fire, theft, and temptation can derail your strategy in a hurry.
4. Credit Card/Line of Credit
Unfortunately, many Americans feel that their credit card or their line of credit serves as their emergency fund. From a pure math perspective, I understand the value in trying to maximize the earnings on their cash while taking advantage of the credit available to them. But, I will completely disagree on the psychology behind this move.
What happens if this becomes a habit and you start putting yourself in a position where you aren't able to pay the bill in full? The interest you'll pay against that debt is WAY more than you can guarantee yourself in earnings on that cash.
What happens when the only contractor that can fix your air conditioner quickly and reasonably requires payment by check or cash?
Credit cards and lines of credit have their place, but it's not in the emergency fund realm. At best, you'll want to consider these as a backup emergency fund.
How Much Money Should I Have In My Emergency Fund?
If you've spent any time scrolling social media, reading articles, listening to podcasts, or watching YouTube, you'll come to realize that every "financial guru" out there has the answer. They'll tell you that you need 6 months of income, or 6 months of expenses, or 12 months of income, or 12 months of expenses, or 5% of your net worth, or $1,000 - but what is the right answer for YOU?
I hate to sound like a lawyer, but it depends.
I'm not the world's biggest Dave Ramsey fan, but his basic emergency fund advice isn't bad, especially if you have serious debt issues or have problems saving money. I could go without the tough love, the religious pandering, and the zero-context investment advice, but the emergency fund and debit advice is valuable. Here are some general guidelines and ideas to get you started:
BEGINNER FUND - $1,000
If you're starting from scratch, you'll definitely want to build a small emergency fund first. I don't hate the Ramsey idea of using $1,000 as your first goal. Here are some ideas to help you get there:
- Sell some household items, collectibles, or other things sitting around that you don't use anymore. Online marketplaces such as eBay, Facebook Marketplace, Craigslist, and Mercari have made this super easy.
- Start a regular transfer from your checking account into a savings account through your bank. Even if it's just $25/month to start, it's putting you on the right track. You'll start to get used to the habit and realize you can put away more and get to your goal much faster.
- See if your employer offers the option to split your paycheck between two different accounts. Set it up so that part of your pay automatically goes into your savings account. You won't miss the money, and you'll have a nice little rainy day fund in no time!
INTERMEDIATE FUND - 6 months of living expenses
Once you've built up your first $1,000 (great job, by the way!) - it's time to graduate to an emergency fund that will give you peace of mind for 90% of the storms you could face.
Your next goal should be having 6 months of living expenses stashed away in a safe, liquid account. It's important to nail down a monthly living expenses number. Now, what exactly do we want to consider as "living expenses?"
This answer will be different for everyone, depending on your situation. Obviously, we want to consider basic living expenses like mortgage/rent, utilities, food, insurance, etc. The variance comes into play when we consider things that are borderline between necessity and discretionary. Cable, Internet, cell phone, subscriptions, etc.
If you lost your job and found nothing for 2 months, are you willing to go with a lower-speed Internet? Ditch the cable package? Find a low-cost cell provider? Put the streaming subscriptions on pause? If you are truly willing to make those sacrifices, then when you're figuring out your monthly expenses, assume that you'll make those changes and plan accordingly. If you're absolutely not willing to give up your 4k multi-TV Netflix subscription, then you need to count it toward your living expenses for your emergency fund.
This strategy will also vary greatly depending on whether you're married, single, living with roommates, etc. Do you want to have 6 months of total living expenses for you and your spouse? Do you just want to cover "your" expenses and half of the joint expenses? It depends on how you manage your money day-to-day.
Talk with your spouse. Money problems/disagreements are a leading cause of divorce. Divorce is expensive and heartbreaking. Talking is much easier, and cheaper.
ADVANCED FUND - ???
Once you've managed to save enough to cover 6 months of living expenses, you may be all set with your emergency fund, or, depending on your situation, it may be time to move up into a larger emergency fund. What are some things that would constitute having a larger emergency fund?
Variable Income
If one or both spouses has a variable income (commission-based, gig worker, business owner), you will likely want a little extra cash cushion to get you through lean months (or even years). I believe anyone with a highly variable income should have at least 12 months of living expenses tucked away in a safe, liquid account. When I started my business, I made sure that I had enough to get me through 12 months without having any income.
High Fixed Expenses
Many Americans find themselves with a mortgage/rent, two car payments, and a multitude of other bills. If your bills are a high percentage of your take-home pay, you'll likely need a larger emergency fund. If those bills include credit cards and/or personal loans, you'll want to tackle that debt first before building a bigger emergency fund. If not, you'll just end up paying a ton of money to your lender and getting nothing in return.
Children
Kids are expensive. I've seen studies that claim the cost of raising a child is in the multiple 6-figure range. You'll certainly want a larger emergency fund to cover unexpected expenses for the little ones. 12 month minimum.
Takeaways
There's no definitive right or wrong way to do this. Just follow the general guidelines and you'll give yourself and your family the peace of mind that you deserve. If you'd like 1-on-1 help with building your emergency fund, tackling debt, or any other financial topics - book your introductory call here.