We’re up to step 5 of How to Get Control of Your Money. By now, you know exactly how big of a mess you are in. But, you have created goals to help you get out of that mess, have organized your bills and automated your payments so that you never pay another late fee again, and have worked on improving your cash flow to turn consistent deficits into consistent surpluses! Great job so far. Now it’s time to put that surplus into the right places – And the first place that you want to begin putting that surplus is into an Emergency Fund. If you’re unfamiliar with this personal finance term, an “Emergency Fund” is simply money set aside for no other reason than to financially take care of unexpected expenses, or life’s little and big “emergencies.” Your emergency fund is essentially your way of guarding against having to use credit cards to take care of these emergencies. As unexpected life events and expenses come in all sizes, so should emergency funds, leading up to a fully funded emergency fund that can cover surprises both big and small. I’ll categorize the progression of your emergency fund into three phases to help you better understand my recommended emergency fund sizes.
Starter Emergency Fund
The first phase is what I call a “starter” emergency fund. It’s simply enough funds to cover a fairly large expense. What exactly is “fairly large” will of course depend on your particular circumstances. The size of your starter fund will be a bit bigger, for example, if you own a home, since you presumably own more expensive items that could break down, or it could be smaller if you’re single with a paid off car and living in a one-bedroom apartment. Your goal here is to identify what could reasonably go wrong and then build up a cash reserve that could take care of those possible surprise expenses. For my Wife and me, that amount was $1,000-$2,000 while we were paying off debt. This amount came in very handy when I needed to have an unexpected appendectomy and the hospital bill came out to about $1,000. Whatever amount seems right for you, go ahead and build up your starter emergency fund to cover these potential expenses.
Major Expense Emergency Fund
The next phase of your emergency fund is what I call the “Major Expense Emergency Fund.” This is an amount of money meant specifically to cover expenses that may not come around very often, if ever, but if and when they do come, are a major expense to handle. Examples include having a roof replaced, having to buy another car unexpectedly, or needing to replace an AC Unit. These are all expenses that could easily cost hundreds or thousands of dollars more if simply addressed with a credit card and then left to monthly payments. Again, your circumstances will help determine the actual size of your Major Expense Emergency Fund, but an amount between $2,000 and $10,000 should do most folks just fine.
Major Event Emergency Fund
The final phase that you’ll want to bring your emergency fund up to is what I call the “Major Event Emergency Fund.” This is an amount money that, God willing, you will never have to use, but should set aside just in case you experience a life changing event and need a store a cash to live off of while you recover. Examples of such events include an unexpected job loss, an unexpected disability, or an unexpected long-term illness. It’s at this point that you can think of the right amount of funds needed within this account in terms of time, as in enough money to live off of for 3-months, 6-months, 9-months, etc. The exact amount will depend on your expenses and the level of lifestyle that you want to keep up while living off of this cash reserve. However, most personal finance gurus suggest 3-6 months worth of living expenses saved up. Personally, we have about 6-9 months of living expenses set aside in our Major Event Emergency Fund.
Where Should I Keep My Emergency Fund?
You’ll want to strike a balance between accessible when needed (within 1-2 days) and not so easily accessible that you’re tempted to spend it on frivolous items. An online savings account that is not connected to your checking or credit card accounts should do just fine. If you have more discipline, a simple savings account at the same bank as your checking account will work. Either way, keep the funds separate from your main checking account and, preferably, not directly tied to a debit card.
Debt vs. Investing While Building Emergency Reserves
What about paying off debt or investing while building up your Emergency Fund? Delaying attacking debt during this process will cause you to incur additional interest costs. You should know by now how hurtful compound interest on debt can be. Delaying investing during this process will cause you to incur opportunity costs, or in other words, will cause you to miss out on the positive power of compound interest on your investments. Of the two – Debt vs. Investing – I suggest attacking debt first, but only AFTER you have built your Starter Emergency Fund. Once your Starter Emergency Fund is in place, you can decide from there the right mix of continuing to build up your emergency reserves and paying off debt, based on your particular risk tolerance and circumstances. For example, if you have a very stable job, are very healthy, and everything that you own is in very good working condition, you may want to heavily or solely attack debt after completing your Starter Emergency Fund. Conversely, if you drive a car that is on the verge of losing its last wheel and your roof is so thin that the next bird that lands on it will cave it in, you may want to wait a bit more on paying off debt until you’re closer to building up your emergency reserves to “Major Expense” status. How about investing? I suggest only investing after 1) your Starter Emergency Fund has been completed AND 2) all debts have been paid off. The only exception to this would be funding a 401k where there is an employer match – get that free money! Else, you’re better off paying off higher interest debt first.
With the above progression in building up your emergency reserves, you’ll be well on your way towards building real wealth. Next up we’ll discuss knocking out debt.