What do you do when the unexpected happens? Your car breaks down, a recent trip to the doctor results in a large bill, you lose your job, or any of a multitude of unfortunate financial occurrences. Life is unpredictable and certain events can wreak havoc on our finances. Although events like these can be painful, we can prepare for them in advance by creating an emergency fund. An emergency fund is money that is set aside in case of an unexpected financial event. It typically consist of 3-6 months of necessary expenses. Although the importance of an emergency fund can’t be overstated, establishing one can be difficult, especially if you’re strapped financially. I’ll walk you through the basics of an emergency fund as well as how I was able to free up income so that I could save for the unexpected.
Emergency fund basics
Financial emergencies come in many shapes and sizes; some large and some small. Because of this, it’s important to set aside money to cover a variety of scenarios. Your emergency fund should cover 3-6 months of necessary expenses, getting as close to six as possible. Necessary expenses include things like food, mortgage or rent, transportation, and debt.
The easiest way to calculate these expenses is by adding up what you spend on necessities in any given month. Once you’ve figured this out, you can multiply it by 3 or 6. This will get you to the amount you should aim for. Keep in mind that an emergency fund should not be treated as a rainy day or vacation fund. This money should only be used for true emergencies.
Building your emergency fund
If you have extra money to contribute to your emergency fund, and you don’t have one already, start saving. When I got started I didn’t have much money to save, so I had to review my financial situation and see if I could either reduce my expenses, eliminate unnecessary expenses, or find a way to make more money. Consider doing the same.
If you haven’t already, check out my blog post about reducing expenses. I go into detail about how I was able to reduce expenses without dramatically impacting my day-to-day life. For example, I was paying way more than I needed to for internet, and ended up saving $40 per month by downgrading the plan I was on.
In one of my other blog posts, I go into detail about identifying and cancelling unused subscriptions. As it turns out, I was paying for various products and services that billed monthly or annually that I forgot about over the years. By cancelling these unused subscriptions, I was able to save $85 per month. That’s $1,020 annually! So if you haven’t done so already, review your bank transactions over the last 12 months. You can identify and cancel subscriptions you no longer use and free up money to put towards your emergency fund.
Finally, check out my post on controlling spending. Eating out, impulse buying, and keeping up with the Joneses can be costly. Eating home cooked meals and making wise and well thought out spending decisions can free up a chunk of your income.
Automatic transfers are your best friend
Automatically transferring money into your emergency fund is a best practice as it does all the work for you. You don’t have to worry about forgetting. When setting up an automatic transfer, be sure it’s for an amount you can afford and a frequency that works with your finances. This is important. When I set mine up, I was a little too ambitious and had to quickly dial it back in order to avoid overdrawing my account. The last thing you need is overdraft fees due to savings transfers.
On that note, you don’t want transfers to your emergency fund to go on forever. You should be aiming for 3-6 months of expenses, getting as close to six as possible. If you still have debts to pay after reaching six months of emergency savings, consider pausing the automatic payments and redirecting those funds toward your debt.
Cash is king during an emergency
You want to make sure you have the cash to cover most emergencies. Why? You want to avoid going into debt, especially credit card or other high-interest debt as this can exacerbate your situation in the long run. Too many people view their available credit card balance as an emergency fund. If you don’t have the cash to cover emergency expenses and have to resort to a credit card, why do you think you’ll have the cash to make the resulting debt payments? Play it smart and consider putting away as much cash as possible.
Should I pay down debt or save for an emergency.
Both are important. When I had $40,000 in credit card debt, I was struggling financially. I focused on reducing and/or eliminating expenses, changing my spending behavior, and putting in extra hours at work. I prioritized both paying down my debts and saving by leveraging the debt snowball method and contributing any extra cash to my emergency fund. Do not miss debt payments because you are saving for an emergency. Pay down your debt and save when you can.
Do not abuse your emergency fund!
The name says it all. Your emergency fund is exactly that. A pool of money available for an emergency! It’s not to be used for vacation expenses, eating out, or an impulsive splurge on something that isn’t going to get you out of the hole you’ve dug for yourself. Only use it in the event of a true emergency. Until that emergency arrives, pretend it doesn’t exist. The last thing you want is a depleted emergency fund when you need it the most.
One other thing. Don’t use the money for non-emergencies and justify it by saying you’ll pay it right back. That’s exactly the kind of behavior that drives countless people into debt. Excuses and weak justifications are your worst enemy. It’s best to avoid them altogether.
Wrapping it up
An emergency fund is critical to anyone’s financial wellbeing. Aim to have 3-6 months of necessary expenses saved. Avoid any temptation to use it as a rainy day fund or a vacation planning account. It should only be used for financial emergencies. Once the emergency is over, get to work rebuilding the fund. If you don’t have extra cash to start contributing, review your bank statements and see where your money is going. Identify opportunities to reduce expenses or eliminate spending on things that are unnecessary. If possible, set up automatic transfers to your emergency fund so that you don’t forget.
Having an emergency fund has brought me tremendous peace of mind. I sleep much better at night knowing that if an emergency were to arise, I’ll have a cushion to carry me through it. This is in complete contrast to where I was in 2016, always worrying about what would happen if I lost my job or could no longer work extra hours.
So if you haven’t started saving for an emergency, get started on it as soon as possible. Not only will an emergency fund bring you peace of mind, it will also bring you some financial certainty in trying times.
You can read more about emergency funds here.