Add a little superpower to your finances – the Emergency Fund
Yay, the shutdown is lifted! I’ve been moved by the many stories from people who want to work, who agree to work, who go to work, but who are told that they won’t get paid for their work. I imagine the demeaning, defeating feeling it must leave, on top of stories of real financial hardship. The shut down, as well as events in my own life, are causing me to reflect on a quiet, deeply powerful tool of financial protection – the emergency fund.
An emergency fund is kind of like Violet’s superpower (from the Incredibles). Violet has a force field to deflect incoming bullets, giant mechanical squishers, or at times, her brother. She uses her force field to protect against the unknown and unexpected. In your finances, villain bullets come at you as a job loss, a tax bill, a trip to the emergency room, or even a wealthy friend getting married – “Hey, guess what? We’re having a destination wedding in the South of France in the middle of the school year!” To protect against the unexpected, you should have a cash force field – an emergency fund. A good emergency fund deflects, or at least softens, the pain and stress caused by unexpected financial hardship.
You lose your job for 3 months? You can still pay your mortgage and buy food from the emergency fund.
Your tax preparer informs you that you actually owe $5,000 for last year’s taxes AND you have to pay your first quarterly tax bill for the next year of $2,400? All in April? You pay for it from your emergency fund.
Your transmission goes out? Emergency fund.
Your friend says that they found this nice little villa where everyone in the wedding party can stay for “just” $2,000 a night, split four ways?
You get the message. Your emergency fund is there for you.
What is an emergency fund?
An emergency fund is just a pot of money. It should have the following characteristics:
Accessibility. The account should be accessible, but not too accessible. Just don’t have a plastic card attached to it. To get your money, you should need to open a website, enter your password, cuss as you realize that you just changed it last time and never wrote it down, do a password reset, maybe cuss again, then transfer the money. Create a small hurdle between you and your emergency fund.
Liquidity. The cash should be quickly available. Don’t invest the money in a longer-term investment where the risks of the market could make it a “bad time to sell.” If you are already stressed for cash, you don’t want to add the stress of “Is now the right time to sell?”
No cost. There should not be a cost for you to use the money. This point may seem obvious, but I’ve heard some people say that their credit card (with a $15,000 limit) is their emergency fund. Nope. That’s not a force field. That is called having a “friend” with a force field, who also happens to be a ruthless drug dealing-gangster. They may help you out, but at a steep price. Using credit cards as a back-up plan is dangerous – a prescription for sickness rather than health. I also hear people say that their long-term investment account (like a retirement account) is their emergency fund. Nope, also not a force field. Your retirement accounts should be for your future self, not your now self. What about the using ability to take a loan against your 401k or a life insurance policy as your emergency fund? Nope, fails the “low cost to you” test.
How much should you have in your emergency fund?
For most people, it is recommended to have between 2 and 6 months worth of living expenses in their emergency fund. If your family needs around $6,000 for monthly expenses, that works out to between $12,000 and $36,000. Exactly how much is right for you is the financial planner’s favorite answer, “It depends.”
If your family has VERY stable income and expenses, you can get away with a small emergency fund. However, the more uncertainty in your life – kids, pets, jobs, etc., the larger your emergency fund should be.
A good emergency fund is also a good investment
How’s that? How could an account, earning maybe only 2%, also be a good investment?
Your emergency fund is your protection against high cost debt. So, if your emergency fund buffers an expense that you otherwise would have needed to put onto your credit card charging, say 13% (or more), you’ve just “made” 13% on your investment. As Benjamin Franklin said, “A penny saved is a penny earned.”
The trap: no emergency fund, and no funds to build one
If you don’t have an emergency fund, and you don’t have extra money at the end of each month, you may feel trapped. Perhaps you are already in credit card debt. Your situation is likely tricky, and you may want to reach out for some help. You could hire a personal financial planner, or there may be low-cost (maybe free) community resources for you. Ask your local credit union or community college for “financial counseling” resources. Just make sure that you are working with a philanthropic organization, and not someone using a “free offering” as a lure into some product sales. If you just want a do-it-yourself approach, try following these guidelines:
- Pay yourself first. Start a habit of putting a little money from each paycheck into an emergency fund account. You’ll be surprised how quickly a balance can grow if you put it on auto-pilot. Plus, if the money is immediately swept away from a spending account, people are often pretty good at making do with what they have.
- Pay off your credit cards! Find the highest interest card, pay it off as quickly as possible. If you are spiraling into credit card debt, stop using the credit card.
- Find an accountability partner. Find someone you love and trust. Tell them your pain, and your plan. Ask them to check in with you every couple weeks. A simple phone call or text can make a big difference.
My emergency fund story
Right after getting married, my wife and I got our first professional jobs, and we had some excess income. We bought a car, and paid it off as soon as possible. We shifted the money we were putting into a car payment into our emergency fund. Within a year, we basically had 3 months living expenses. Since then (15 years ago), we’ve kept the fund between 2 and 3 months salary. Until this year, I’ve been working full time as a high school teacher, so my income was predictable and reliable. My wife is self-employed, so her income tends to be much lumpier. For our lives, two to three months was sufficient.
However, this year, I cut back on teaching to half-time. My employment income dropped in half. Part of my income now comes from self-employment, which is less predictable than a paycheck. I’ve noticed our emergency fund balance has become quite volatile. Over the last year, our fund has veered dangerously close to the ground a couple times; it dropped to $700 last summer, and about $1,200 once this fall. I find that very stressful. I am the number cruncher and book-keeper, so I get pretty nervous when I don’t know how we are going to pay a bill. I’ve once been in a downward credit card trap, I don’t want to go there again.
When our emergency fund fell to $700, I did not feel good. I was anxious. My stress was caused by a too-small emergency fund. In our new self-employment reality, we need to pump up our emergency fund to at least 4 months of living expenses, 6 months would be better. But, that is a big chunk of change. It will require us to be careful budgeters and spenders. Fortunately for me, my wife’s superpower is to not spend money. We’ll get there over time.
When Violet feels unsure about herself, she loses her ability to conjure her superpower. Her force-field becomes fickle, wavering. Life is that way, we all go through periods of frailty and strength, uncertainty and confidence. But, the emergency fund works in the opposite direction. By having a robust emergency fund, you grow your own strength, confidence and resilience. An emergency fun, or at least a feasible plan to build one, should be a part of any good financial plan. In finance, you get to create your own super-powers.