Anything that can go wrong, will go wrong.- Murphy's Law
"The only thing guaranteed in life are death and taxes." We are going to add one more to that list:
Unexpected Financial Emergencies
Your car will break down at the worst time, the hot water heater will go out in the middle of winter, and your child will break their arm and run your insurance deductible to the annual max.
OK, maybe these specific cases are not guaranteed to happen, but something surely will. It won’t be a one-off event, rather a common theme throughout your life. Even the most prudent planners get caught off guard from time to time.
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Emergency or Inconvenience?
No one likes unexpected expenses. For many, expenses that pop out of nowhere can be catastrophic to not only their finances, but their overall well-being. For others, these unforeseen costs are merely an inconvenience that need to be handled.
What is the difference between these two groups? Emergency funds.
No matter what you call it, having cash set aside can be the difference between ground shaking financial issues, and minor inconveniences that need your attention.
What is an Emergency Fund?
An emergency fund is a stockpile of cash (or cash-like investments) that is earmarked specifically for emergencies. It’s money accumulated and set outside of your monthly budget so you are not tempted to spend it.
When unexpected expenses come up and there is no extra cash available to cover it, one of three things generally happens:
- The expense ends up on a credit card (or other debt).
- Money is diverted from necessary expenses to cover the emergency.
- Nothing, and the consequences of ignoring the emergency are realized.
None of these outcomes are optimal from a personal finance standpoint. Number one is the most common result for people with access to credit, which negatively compounds their overall financial situation due to increasing their debt and monthly payments.
Save $5,000 Now
In Steps 1-3 the focus was primarily on planning and restructuring. Here in Step 4 we start to work on tangible results.
The goal of this step is to save $5,000 as quickly as possible so you have a basic emergency fund as we work through the final steps. The last thing you want is an unexpected expense to derail your momentum and tack on more debt.
If it will take you more than three months to accumulate $5,000, use $3,000 as your target. The main purpose of this step is to put some cash between you and life’s surprises.
If you don’t have one already, set up a high-yield savings account with an online bank. Two of the most popular are Ally and Capital One 360, but just about any of them will do. It may be tempting you use a savings account at your current bank, but we advise against it. The extra day or two it takes your money to move between accounts can help prevent impulse spending of your emergency fund.
Hyper-Focus on Saving
If you are truly committed to changing your financial life, get to this savings goal as fast as you can. Don’t lose the momentum you currently have.
Tips to speed up the process:
- Use your budget from Step 2 and find buckets to cut back
- Reduce retirement savings temporarily (keep the employer match, if applicable)
- Suspend other savings goals (like college)
- Sell stuff lying around your house
If you choose to reduce other savings goals (like retirement and college), make sure you are directing the funds into your emergency fund and not spending them. These reductions should be temporary, and we will address them in Step 5 when we set it all on autopilot.
Some people may disagree with reducing retirement funds temporarily, citing the missed opportunity for tax-deferment. If you are committed to the process, missing a few months of contributions will not have any long-term effect on your overall financial success. The real risk is becoming complacent and falling into your old habits because you are not making progress through the Steps.
I Already Have $5,000
If you already have an emergency fund set aside, this step will be a breeze.
As mentioned above, set up a separate savings account and move the funds there. If you have more than $5,000 that isn’t earmarked for something else, put it all in there for now. When we get to Step 6 we will discuss how to best use any excess cash that’s available. Hint: Pay down debt and/or finish building a fully-funded emergency fund.
How to Use Your Emergency Fund
If you have never had an emergency fund before (even a small one like this), we guarantee it will make you feel more confident about your finances. Some people call it, “a sleep well at night fund,” because it can literally do just that.
Besides helping you sleep at night, your emergency fund is there to provide support when your plan doesn’t go according to plan.
When a financial emergency pops up, use the cash from your savings account rather than floating it on a credit card. The goal here is to prevent adding more debt and interest to your cards. When trying to get out of a hole, the last thing you want to do is keep digging.
If you need to tap your emergency fund, your next objective is to fill it back up before its needed again. That means revisiting your budget and cutting back, if necessary. You should always have $5,000 in your emergency fund or be in the process of filling it back up.
Christmas is NOT an Emergency
Emergency funds are reserved for true emergencies. Poor planning and lack of impulse control are not emergencies.
No one is born with a desire to spend all their money, it’s a learned behavior. If accessible cash burns a hole in your pocket, this is your chance to start building new habits.
Bi-Annual Insurance Bill - Not an emergency. This type of expense should be reflected in either the Savings or Variable section of your budget. If you pay $600 every six months, you should be setting aside $100 per month in preparation of the bill.
Girls Weekend Trip - Not an emergency. This type of expense should be part of a Savings goal. A common practice is to set up a Vacation savings bucket that you frequently add funds to. If there is enough money in the bucket, it’s a guilt-free trip.
Nordstom Half-Yearly Sale - Not an emergency. Unless your house burns down and you need clothes to go to work, nothing about this is an emergency. A Clothing bucket fits nicely under Variable Expenses. Fund it each month, and you can go wild at the Half-Yearly Sale.
December 25th - Not an emergency. The Romans started celebrating Christmas on December 25th, 336 AD, so after almost 1700 years there is no excuse for it sneaking up on you. Rather than waiting until the holidays, set up a Savings bucket called Christmas, and add to it every month as if it was a monthly expense. Holiday shopping has a different flavor when the bills don’t follow you into the new year.
Pedal to the Metal
Good is the enemy of great.- Jim Collins
This is the point where it’s easy to become complacent. There is a sense of confidence that comes from having a clearer picture of your finances, and that confidence is reinforced by having extra cash in the bank. Don't let good progress get in the way of great results.
At the conclusion of this Step, you should:
- Know your income and living costs.
- Have a budget and tracking expenses.
- Have consolidated your high-interest debt into lower-cost loans.
- Have a $5,000 emergency fund.
In the final two Steps you will set your long-term savings goals on auto pilot, finish building your emergency fund, and pay off your consumer debt. Now is the time to redouble your efforts, because the life-changing stuff comes next.