I read a recent article that said most American’s (63% of us!) can’t handle a surprise $500 expense. That number shocked and saddened me, and it’s much higher than I would’ve expected. There are a few reasons I think this happens to people. First, overspending and paycheck creep prevent people from getting a handle on their finances. Then when an unexpected expense comes up, they have to go into debt and spend more of their disposable income on debt repayment. Then, they have even less means to prioritize savings.
Yes, lack of earnings growth over the last few years has been a problem. But there are plenty of people out there who earn a good living and still can’t come up with the funds needed to address a surprise expense.
I’ve got some tips to prevent this cycle. Hint: it starts with prioritizing savings over other types of spending. But first let me answer some basics.
What is an emergency fund for?
You should be concerned about saving for a potential job loss — this includes whether you quit, get laid off, or need to move on to other opportunities and there’s a gap before you start your next role. But job loss isn’t the only thing you should save for. Insurance deductibles, major home or car repair, injury, dental work, illness or other unplanned increase in expenses could create major cash flow problems for the average family. If you’re a homeowner, you should make sure you’re saving extra for maintenance expenses throughout the year, because sooner or later you’ll need to call the repairman.
If you’re a business owner or rely on freelance income, you should increase your level of emergency funds to make up for cash flow shortfalls, liability expenses and or replacement of key equipment. Don’t forget things like computer replacement — what would you do if your computer broke?
These are all things for which you might need an emergency fund.
How much should I save?
You can try and guesstimate a good emergency fund amount based on the list above. However, to keep it simple, it’s a good rule of thumb to keep 3-6 months worth of expenses on hand. Homeowners should also keep at least 1% of the value of their home (more if it’s an older home), in their emergency fund. Freelancers and the self-employed can set aside up to a year’s worth of expenses to be on the safe side.
What if I can’t save that much?
That’s ok, start small. Make saving a priority through automatic deductions into a savings account. Even saving $50 a month can add up over the course of the year. Strive to first save up one month’s worth of expenses, then two, and so forth. Aside from your fixed-cost bills, emergency savings should be one of your highest personal finance priorities.
Where should I put my emergency funds?
Park them in a safe, easily accessible account earning some interest — something around 1%. You want to make sure the cash value in this account won’t decline. I usually see the best deals with online savings accounts or credit unions. Check around and compare rates. Make sure you’re getting a long-term rate and not a bonus rate that will decline in 6 months. The bottom line here is, if you’re only getting .08% on your savings right now, find a new company to work with.
I want to stress, the “easily accessible” and “will not decline in value” concepts. Once you do have a nice cushion, you may be tempted to start investing some of the funds to try and earn higher rates of return. Resist the urge, and keep 3-6 months in the liquid savings account. You’ll be glad you did the next time you need to access the funds and the market has declined by 5%. Don’t dig into investing until you have an adequate emergency fund. Once you surpass that rate of savings, then you can look into investing vehicles that might make sense for you.
How did I (we, as American’s) get here?
If I had to put my finger on it, it’d say lack of focus and lack of education/awareness around personal finance. Perhaps also, the common need for instant gratification prevents us from thinking ahead to the “what-if” moments, which then fuels a lot of overspending and debt spending.
Aside from awareness and thinking ahead, there’s a trick American’s aren’t really using. When bonuses, salary increases, big gifts, tax returns, or other windfalls come, we tend to spend most of it instead of saving. To combat this, ask yourself “What am I going to do with this money?” The first answer shouldn’t be — “spend it.” You should be looking at ways to save some of it and pay down debts first.
How should I prioritize my saving?
“Pay yourself” your savings right after fixed, necessary living expenses. Do this before discretionary decisions come in like entertainment and leisure. If you have debts, you should try to find a balance between paying down your debts and also building an emergency fund. They definitely relate to each other because the absence of an emergency fund will necessitate the need to go into debt when a surprise expense comes up. It’s a good idea to try and sock some money away before you’re completely debt free to prevent that debt cycle from starting again.
How do I motivate myself to save more?
Try visualizing what your emergency fund means to you, or earmarking for specific purposes. Maybe some of these speak to you:
- Prepayment of expenses that you’ll probably incur at some point.
- A rainy day fund.
- A financial freedom fund that would allow you to leave a bad situation at work.
- A fund that will save you a ton in credit card interest because you won’t have to go into debt the next time an emergency comes up.
- A worry-free fund that allows you to breathe easy when you get a big bill in the mail.
Maybe you have some other tricks that might be motivating for you. Feel free to share them with me! Just please don’t be that person who is one emergency away from financial ruin. Follow these tips and start creating more financial freedom for yourself.