This is the fourth of ten posts describing the key pillars of building a strong financial foundation. Read the introduction here. Check back each Monday for the next post in the series.
Have you ever had to put an unanticipated, but necessary purchase on a credit card? Whether you got in a car accident, had medical bills or lost your job, money emergencies happen when you least expect them to. These types of setbacks can hinder the progress you’ve made towards paying off your debt. Instead of using a credit card for unexpected expenses, you can set up an emergency fund to have in case such an event takes place.
What is a Financial Emergency?
Before creating a savings fund for unknown future costs, you must first define for yourself what an emergency would be. If you don’t set boundaries around the money you are putting aside, you will be more likely to use it when you shouldn’t be. It is important to first define what an emergency is not.
Finding a television or pair of shoes on sale is not an emergency. Going shopping on Black Friday is not an emergency. Refilling your checking account with money because you spent more than you should have eating out last month is not an emergency. Each person has to figure out for themselves what an emergency is for them, but here are a few of the things that I would potentially use my emergency fund for.
- Unexpected Medical Expenses
- Job Loss
- Major Car Troubles
- Death in the Family
- Hopefully Nothing
Save an Emergency Fund First
The main reason you want to have some savings on hand before you try to pay off debt is that if you happen to stumble financially, you don’t have to rely on your credit card to pay for it. If you didn’t have an emergency fund saved up you would end up increasing your debt again if something unexpected happened.
Think of your emergency fund like training wheels on a bicycle. When you first learn to ride a bike (or get control of your finances), you may waver side to side until you can consistently head straight towards your destination. While you may have relied on your training wheels when you were younger, after enough practice you could take them off and never look back.
An emergency fund is like training wheels in the sense that when you are first building a strong financial foundation you will want to have a safety net to catch you if you falter. Without some savings on hand you may fall into the same cycle you were in before, such as living paycheck to paycheck. By setting aside a small amount of money at the start, continually contributing to it and keeping it safe, you can power ahead in your debt repayment plan. Savings goals are easier to accomplish knowing that if something unexpected happens you’ll be prepared to handle it.
Decide on a Number
There are many different theories on how much to save in an emergency fund. Popular personal finance writer Dave Ramsey recommends just $1,000. Others recommend that you save two months worth of expenses per dependent. My recommendation is to save what makes you feel comfortable. Whether you spend hours figuring out exactly how much money you could live off of for three months if you lose your job, or you just pick some pie in the sky number in your head, decide what is best for you and stick to it.
Make it Automatic
You might be saying to yourself, “But how I am supposed to build up an emergency fund when I am already drowning in debt and living paycheck to paycheck?” The answer is in the age old principle of paying yourself first. When you get paid, immediately transfer a certain amount into a savings account specifically for an emergency fund. Then live off of the rest of your money.
Better yet, set up direct deposit at your work or automated savings transfers at your bank so that you take the thinking out of it. Start small with only ten or twenty dollars a week. You may be surprised how much you can save when you start focusing on how you are spending your money.
Where to Keep Your Emergency Fund
Ideally you want to have the money be accessible, but not overly so. You want to be able to get at the money when you need it, but have there be some sort of barrier to keep you from using it for non-emergencies. You wouldn’t want to keep the emergency fund in cash either because you will want to get some return on your investment.
I first kept my emergency fund in a savings account of a bank that I didn’t use for my regular checking account. If I needed to, I could transfer the money to my regular checking account in a few days. This was the only deterrent I needed to never touch the money in my emergency fund. Once I had the emergency fund to the desired amount, I invested it in a Certificate of Deposit to get a better interest rate.
Whether you are just starting to pay off debt or have a large net worth, it is always a good idea to have an emergency fund in place for when the unexpected happens.
Financial Foundations Series