You would have noticed one of the steps to financial freedom is building an Emergency Fund. Notice it is capitalized. Why? Because it is important.
So, what is it? Very simply, it is a pool of money saved for a rainy day i.e. an emergency. And we don’t mean the sudden deep desire for a new phone, tv, or hand bag. These are all discretionary (avoidable) purchases and not emergencies. The focus here is an unforeseen event e.g. you lose your job or are temporarily unable to earn income, doctor bills, a major necessary appliance needs to be replaced, a car accident not worth claiming for insurance, you sat on your glasses and broke them, etc. The list is endless.
Why do you need an Emergency Fund?
Once we start to live on our own, we learn pretty quickly that it doesn’t matter how well you plan things out; life happens from time to time. Unforeseen events occur. While you are unable to identify them in advance, you can be sure something will happen. So if we know something must come up, then it just makes sense to ensure we have funds available to meet it.
Sleep better, stress free
If we know we can financially absorb most unexpected events, it is very liberating. And when the event does happen, we take it in stride.
You avoid debt
If you do not have an Emergency Fund, the default action for most of us is to use credit i.e. take a loan. And the most easily accessible form of credit is using a credit card or bank overdraft. Yuck! Our suggested roadmap to financial freedom is to reduce and eliminate debt. Not adding to it in an unmanaged way.
We discuss this in the section Manage Your Debt.
Is it part of retirement savings?
Saving for your future goals, such as retirement, is a different matter, and is a function of the budgeted level of savings you set for yourself. Your Emergency Fund is not part of your retirement pool.
You just can’t say with certainty when or on what. But since you know it will be spent, it cannot be considered surplus.
How much do you need?
This will vary person to person. For example:
- The more variable your income, the higher the Fund should be
- The more stable your job, the lower the Fund could be
- The higher your fixed expenses, the higher the Fund should be
- If you want greater peace of mind, then the higher the Fund should be
Nice to know, but we bet you still want a more specific guide. Try to take the approach of thinking about what your situation would be if you had no income e.g. you lost your job. How long would you take to get an appropriate replacement opportunity?
In our case, as we are “professionals”, taking a job below your skills and experience is a career and income setback that could take a while to recover from. So we wanted to ensure we had enough time to find the right job, without being forced to accept something because we were running out of money. Earlier in our career we thought having enough cash set aside to cover six (6) months of budgeted expenses was sufficient. As we became more senior (and therefore the number of possible jobs diminish), we increased the number of months of expenses that we wanted to cover.
Please note this guidance will vary from advisor to advisor. We are merely describing what worked for us. In a way, this was the “worst case” approach. It required a bit of sacrifice, but we were able to sleep really stress free.
The simple point being it is better to have something set aside rather than having zero. Just start and build it up.
Make it accessible with a little hassle
Seeing the objective of the Fund is to cover emergencies, it needs to be accessible at short notice, but we recommend introducing a little hassle to discourage you from dipping into it unnecessarily. For example, if you use a bank account, don’t get an ATM card. That way, you have to stand in line to withdraw – we think that prospect alone should keep you away!
Keep it safe
These are not funds you want to risk losing. We understand if you want to earn a little interest on the funds, but do not take any risks. It has to be all there when you need it.
Make it automatic
As you are building your Fund, the best approach is an automatic deduction from your take-home salary. In which case, you psychologically don’t even realize that you are saving. It’s just not there in the net salary you receive.
How do I start?
The faster you build up your fund to the level you designate, the more comfortable you will feel. So the reality is, after you set your target budget, all budgeted savings needs to be firstly directed towards building this pool of cash.
But in one form or another, we usually get “unanticipated” cash or could raise cash (the most obvious being to sell something that we no longer use). When these “windfalls” occur, you should just forget about them and put the money into your Fund. You’ll be surprised how quickly it could grow.
We suggest you read on to The Budgeting Series, where we show you how to create your personal budget.