Emergency Funds – Why You Need One Yesterday
No matter who you talk to in the financial world, you will always here that you need an emergency fund. The importance of an emergency fund cannot be overstated. Too often people back themselves into a financial corner by not being prepared for the worst.
How often does a car breakdown, or a repair job is needed in your home? There is a reason they call these assets money pits. An emergency fund will allow you to not be caught off guard by these “surprises” that seem to happen all the time.
Why Should You Keep an Emergency Fund
Financial surprises are lurking around every corner. They always seem to cost a couple hundred or a couple thousand dollars, and they always seem to hit you at the worst possible times. What’s worse is that they seem unrelenting, never willing to stop piling on when you can’t handle any more financial burden.
An emergency fund is setup to make sure your finances don’t get the better of you. It is that quick stash of cash waiting to be deployed at a moments notice. This isn’t the same stash of cash that you are saving for that house down payment, wedding, or next vacation. This is a separate stash that is solely meant for emergencies.
Tapping into other financial sources or savings during these times will only derail your goals. Can no longer take that vacation you’ve been planning because you had to replace the air conditioner in your house? That hurts.
That is if you are even lucky enough to have other savings to tap into. Most people don’t have the kind of savings laying around that can be easily shifted to cover the financial turbulence they are experiencing.
This is the easiest way to get yourself into debt. You will let these burdens hit you without any savings, which cause you to take out loans or put something on a credit card. You may think that you can easily pay off a small loan or knock down your credit card debt. You have good intentions but then another emergency hits you and you must deploy more credit. This is a never-ending battle that is incredibly easy to get behind on. It only takes one or two big emergencies to really put your underwater on debt.
By establishing an emergency fund, you protect your present and future self. Think of how stress free you will be knowing you have the cash available to fix an emergency right now. Future you will also thank you for not robbing them of their retirement. Retirement is a balance between you in the present moment and you in the future moment. One of them must make a sacrifice to benefit the other. Don’t let an unforeseen emergency be that sacrifice for your retirement.
How Much Should You Keep in an Emergency Fund
The biggest emergency you are most likely to face is losing your job. Now you can no longer cover any of your normal bills and you could find yourself deep into debt by the time you get your new job. When thinking about how much you should keep in your emergency fund, this is the emergency you should prepare for.
When you lose your job there will be some bills that still need to be paid and some bills that you can get rid of. This is the difference between discretionary spending and non-discretionary spending. Non-discretionary spending are all the bills you must pay, your mortgage, utilities, car note, and some food bills count as non-discretionary expenses. Discretionary expenses are the ones that you can get rid of when the times get tough. Your Netflix subscription, gym membership, and eating out at fancy restaurants all count as discretionary expenses.
The first thing you need to do is look at your monthly expenses and decide which ones are discretionary and which are non-discretionary expenses. Total up all your non-discretionary expenses. These are the expenses we will need to replace with our emergency fund.
If you are single or have only one income in the household, you need to cover a minimum of six months of non-discretionary expenses. This will give you enough time to find a new job and still be able to live your life.
If you are married or have two household incomes, you need to cover a minimum of three months of non-discretionary expenses. If one person loses their job in the house, the other person will still have an income. That income may not be enough to cover all of the expenses but it will help.
Where to Invest Your Emergency Fund
Having a lot of cash sitting on hand can be a real drag on your overall portfolio. Cash usually establishes a negative return due to inflation. Unfortunately, having your emergency fund in cash is vital. Emergency funds need to be liquid and easily accessible. Liquidity is the quickness at which you can deploy your assets. There is no asset quicker than cash. If you hold an investment, you will have to sell that investment, and possibly wait for that investment to settle. A house would be an illiquid asset. It takes a lot of time to sell a house and turn it into cash.
Your emergency fund needs to stay in cash. You don’t even want to tie it up with a CD or short-term bond. Trying to make a large return on your emergency fund is not the number one priority. By keeping it in cash you can easily deploy it at a moments notice.
The best way to “invest” your emergency fund is by placing it in a high-yield savings account. The Goldman Sachs Marcus and Ally Savings Accounts are some of the best available rates and accounts. Don’t pick a high-yield savings account that you cannot quickly access and move the money. If it takes a few days to get the money out of the account, it is no longer liquid. Make sure the savings account you do have is FDIC insured. If they go out of business, you will still be able to get your money back. A lot of brokerages will release high-yield savings accounts, but they will not be insured.
Pay Off Debt or Save in an Emergency Fund
Is it better to pay off your current debt or establish an emergency fund? That is a tough question because debt usually comes with high interest rates which increases the debt, but not having an emergency fund can cause you to get into more debt by not being able to cover the next emergency. With little cash to use, you must decide on where to use it.
The answer is going to be somewhere in the middle. You need to both pay off your debt and establish an emergency fund. When you are in this situation look to make minimum payments towards debt while building up your emergency fund. For your emergency fund aim for a goal of $1,000. This probably won’t be enough to cover your non-discretionary expenses for 3-6 months, but it will help keep you out of debt from smaller emergencies. Once you have your emergency fund established, begin paying down your debt. Once you have your debt paid off, put that extra money into your emergency fund. This system will help keep you in front of your finances and not playing catch-up.
Emergency funds are vital to your financial success. They make sure that a small, like a broken-down car, or large, like a job loss, emergency doesn’t derail your financial future. Build your emergency fund to cover a minimum of 3-6 months of non-discretionary expenses. Remember, you can remove discretionary expenses from your life, but those non-discretionary expenses need to be paid. Your emergency fund needs to remain in cash. Liquidity and easy to access is key for an emergency fund. Look to invest your fund into a high-yield online savings account. This will at least allow your money to keep up with inflation.