Emergencies happen. We all like to think that we’re immune from them and that they only happen to other people. And then, bam! Out of the blue, you get in a fender-bender or something stops working on your car and you owe $750. Or, a water pipe bursts and floods part of your house, and while it’s covered by insurance, part of the cost is out of pocket; but you also have to pay your deductible. How are you going to pay for it? Even with insurance there are still out of pocket expenses that we have to be ready to cover.
HOW OFTEN DO EMERGENCIES ACTUALLY OCCUR?
According to the most recent financial security index survey by Bankrate, 34% of Americans were hit with an unexpected, expensive emergency in 2017. These could be anything from medical, car, housing, or “other” sources of the bill. The average cost of these emergencies was $2,500!! Shockingly, only 39% of Americans said they would be able to pay cash for “just” a $1,000 emergency with the rest saying they would have to borrow money on a personal loan, borrow from family or friends (what does this do to your relationship?), or pay for it with a credit card. Another survey found even worse data, with only 56% of Americans being able to cover a $400 emergency with cash!
Paying for emergencies with credit cards ends up costing you more over time. Lower income earners were more likely to pay for it with a credit card. And remember, those with lower credit scores have higher interest rates on their credit card, which further makes this a terrible option. The problem is, what do you do when it’s your only option? The interest adds up, and your emergency becomes more expensive over time. This creates a horrible cycle in which that one-time emergency continues to haunt you and take more and more of your hard-earned money over time! We have to find a way to stop the madness! We must find other ways to cover the expenses before they happen.
THE EMERGENCY FUND
There is only one way to address the issue of unexpected expenses, and that is with an Emergency Fund with enough money to cover 3-6 months of your fixed and variable monthly expenses. (Expenses is the key part of this equation, many financial bloggers talk about covering your income, but you need to cover your expenses)It is suggested that losing your job would produce the largest financial strain on you, and that it would take up to 6 months to find another job. So, that’s where this 3-6 months of savings comes from. Now, just because you have a stable job doesn’t mean you don’t need an emergency fund! You still need one, but it might be closer to the 3 months of expenses rather than the 6 months. The amount of money you spend every month of fixed and variable expenses determines the amount of money you need to have saved.
Your fixed expenses are those that don’t change month to month, such as rent/mortgage, insurance premiums, loan/debt payments, and child care required for work. These expenses are typically some of the most important ones you must pay.
Variable expenses refer to those that, while still very important, tend to change more in the amount you pay each month. These are your utilities, out of pocket medical/dental expenses, transportation, entertainment, food/groceries, and all other expenses. Of these, there is much more room to cut back on spending.
Utilities, transportation, and groceries are your top 3 in priority during a time of financial crisis. You must cut back on entertainment, eating out, clothing, gifts, and other non-necessity types of expenditures! It’s hard to cut back spending, but if you’re currently in a financial crisis it is crucial to get you back on your feet ASAP. Use the spending tracker from Budgeting 101 to determine what your monthly fixed and variable expenses are. Take that times 3 and 6 to find the minimum and maximum that you need to have in a savings account.
The lower limit of Emergency Fund amount = (your average fixed monthly expenses + your average variable monthly expenses) X 3 months
The upper limit of Emergency Fund amount = (your average fixed monthly expenses + your average variable monthly expenses) X 6 months
This will give you two numbers, for the sake of simplicity, we’ll say the top equation = $10,000 and the bottom equation = $20,000. You should aim to get $10,000 as soon as possible into a savings account and over time make small, consistent monthly contributions until you build the fund up to $20,000.
WHERE SHOULD I KEEP THE EMERGENCY FUND MONEY?
There is some freedom of choice here, but there are better options than others. In general, your emergency savings must be in cash or a cash equivalent, such as a savings account, checking account, or money market fund. Your Emergency Fund should not be invested in stocks, bonds, real estate, or any other security. Remember, your Emergency Fund is not there to make you money, it’s there to save you money by preventing you from taking out a bad loan at high interest, or having to make high interest credit card payments, or destroying your credit score!
Having said that, there’s a couple ways I advocate for maximizing your Emergency Fund money by gaining at least a small amount of interest.
I don’t recommend keeping your Emergency Fund in your main checking account because the temptation to spend it and replace it later is too high. Plus, checking accounts don’t really pay decent interest. General savings accounts through banks are the most basic and practical place to keep your Emergency Fund, however, their interest rates are also terrible. This leaves us with the two best options: high interest savings accounts or a rewards checking/savings account that pays a high interest rate.
- See this list of high interest online savings accounts. These pay around 1% APR, which isn’t much, but remember that this is not an investment! So, if you can be guaranteed this money will be there when you need it with a simple transfer back to your bank/checking account, you may as well make at least 1% interest on it. And these banks are backed by the FDIC to the $250,000 limit. A little something is better than nothing, and that 1% is still about 17x higher than what your bank will pay you!!
- Rewards checking/savings accounts tend to pay more, but they also come with more requirements. I use Consumer’s Credit Union rewards checking account and it pays 4.59% APR on up to a $20,000 balance. The only catch is, to get that higher rate of interest I have to use my debit card 12 times, spend $1,000 on their Visa credit card, have one direct deposit or ACH debit OR pay one bill each month, access online banking at least once each month, and be enrolled to receive eDocuments.
This is definitely a list of more steps, but then again, they’re paying me 4.59% interest that is guaranteed regardless of whether the stock market goes up or down! This means that I also don’t have to contribute as much to my Emergency Fund because it’s actually making money on its own. At the $20,000 balance, 4.59% = $918 every year (as long as I meet the criteria each month) that gets added to my Emergency Fund. By doing this, I’m essentially getting for free what other people are paying in credit card interest each year! This is a great example of how to make your money work for you or you’ll have to work for it! Keep it simple, Stupid!
WHAT CAN WE DO?
First, minimize anything you do that could potentially create an emergency! This is hard, but look at things such as how you drive (Do you wear a seat belt? Do you speed?), your health (do you smoke?), and even your promotion potential/job security. We all do things that, occasionally, we’re lucky to get away without an emergency or an accident. The issue is, eventually, it will be our turn to be in the 34% of people that experience an emergency. Take steps to minimize the chances that you do suffer an emergency.
Second, you must have an Emergency Fund. Dave Ramsey tells a story about how, before he turned his financial situation around, it seemed like he and his wife were always having financial “emergencies” and fights. He says that, after they got an emergency fund a funny thing happened… they quit having emergencies! They just had bills that they could pay without fighting about them, and it completely changed their life.
I would agree. I’ve been very lucky to have read good financial wisdom from an early age, so I’ve never had an unexpected expense knock me off my feet. The wisdom of having an Emergency Fund has literally kept me from paying interest on a credit card, or being late on a payment, or having to use a payday loan, etc. to cover an expense! This is one area that I encourage you so badly, learn from what people have done wrong and don’t do those things! Learn from people who have done it right and emulate what they do! Build an emergency fund, even if it takes the next 6 months to a year to do it, just do it! You’ll have peace about so many situations that would have stressed you out before.
Third, open up an online high interest savings account or a rewards checking account and begin sending money to it every month. If you already have money saved, it’s easy, just move it over. But, run the math and see how much more you need to be at an amount between 3 and 6 months of your fixed and variable expenses. I recommend seeing how much you’re short of that amount, whichever end of the 3/6 months you decide on, and divide that by 6 – over the next 6 months automatically transfer that much money to the account so that it’s less of an impact on your currently monthly take home pay. Cut back on some of your variable expenses. Not eating out one time per week for a month is easily $100 or more, especially for a family.
Finally, once your Emergency Fund is fully funded with 3 to 6 months of expenses, you should still continue contributing some money each month into the fund to maintain and slowly build it. At this point, you don’t need to contribute much. Even $100 every month into the fund will slowly, steadily increase your emergency savings and if you do have a big expense, you won’t have to focus extra extra money into the Emergency Fund in the following months. This helps you keep your monthly spending more even so there are no major changes to it.
- Have you ever had an unexpected emergency come up that strained your finances? What happened? Was it preventable or did something unexpected happen to you? How did you pay for it? Did it cause any relationship fights/tension? Even if the situation was unavoidable, do you think the stress that it caused on you and your family could have been prevented if you had an Emergency Fund?
- Add up your monthly fixed expenses and monthly variable expenses. Take that number times 3 and 6 to get your lower and upper limits of how much money you need in your Emergency Fund.
- Determine how much money you can send to your Emergency Fund each month until it’s built up to between 3 and 6 months of total monthly expenses.
May you not experience an unexpected emergency, but if you do, may you be well-prepared to pay for it and not stress!