Building an Emergency Fund

Jul 2, 2015 | Accounting, Investments, Savings, Tips, Uncategorized, Wealth Management

 

How to Build an Emergency Fund (and Why You Need One)

by Kristin Wong

via TwoCents

 

You’ve probably heard of an emergency fund. It’s a small cushion of savings to help you stay afloat in case of a financial crisis. For some emergencies, it also helps to use an emergency budget—a deflated spending plan to make sure the money in your fund lasts as long as possible.

Most experts say you should have between 3-6 months’ worth of living expenses in an emergency fund. Some emergencies are small. A $500 car repair, for example, should only be a small dip in your fund. But then there are bigger emergencies, like losing your job. Your emergency fund is meant to help you get by for awhile in those situations, and you want it to last as long as possible, since you don’t have a steady stream of income. That’s where an emergency budget comes in.

When you’re living off of your emergency fund, you want to keep your living expenses as low as possible. It won’t be a fun budget to stick to, but you’ll be happy you had it in your back pocket. It’ll keep your safety net in place as long as possible.

Start with Your Current Budget

To build your emergency budget, you’re going to be comparing it against your current budget, so it’s important that all of your spending is accounted for and updated.

We’re assuming you know Budgeting 101 and have already set up a basic budget. Your emergency budget will be based on that budget.

We’re also assuming you have an emergency fund (because you need one!). Some folks have a high enough net worth and multiple, steady streams of income that they don’t even use an emergency fund. In that case, an emergency budget might not be that useful to them, either. It’s mostly for those of us who would truly depend on our emergency fund in a time of financial crisis.

First, review your current budget and all of its categories. Your budget might be on a spreadsheet or in an online tool like Mint. Either way, pull it up and check out your main spending categories. Make sure they’re up to date. Look at your irregular spending, too—quarterly insurance payments, estimated taxes, annual fees—these should be accounted for in your budget if they’re not already.

You can create your emergency budget in a spreadsheet, on paper—whatever medium you prefer. When I built my emergency budget, I simply tweaked my categories in Mint.

Nix Your Non-essentials

Now that your categories are in front of you, the first thing you want to look at is non-essential spending.

Wants, discretionaries, spending cash—whatever you call these expenses, the plan is the same: cut the stuff you don’t need. Take a look at anything in your budget that isn’t an absolute necessity, then axe it. For me, these categories included personal care, restaurants, and shopping. That meant no haircuts, happy hours, or new toys when I was in emergency mode.

Okay, yes—budgets need some room for fun. Like a diet, if you make them too strict, chances are, you won’t stick to them long-term. But an emergency budget isn’t meant to be long-term. It’s simply meant to keep you afloat in a time of financial crisis. So don’t be afraid to cut stuff out—it’s temporary.

That being said, there are a couple of caveats to cutting every non-essential.

First, consider the cost of ditching your luxuries. For example, let’s say you have cable. You want to get rid of it now that you’re in an emergency, but after your financial situation stabilizes, you plan to get cable again. In this case, you should consider the cost of setting up your box again, taking the old one to a dropoff location, finding the same deal, etc. This isn’t to say you shouldn’t cut this luxury—if you’re truly struggling, it’s not a great idea to spend money on cable. But it might just depend on the severity of your emergency. If you have adequate reason to believe you’ll be back on your feet soon, consider the time, cost, and effort of ditching something just to bring it back later.

Also, you know your spending habits and the details of your emergency. Maybe you feel comfortable keeping a few non-essentials. You may have room to add a few of these back in, depending on your situation. But first, you should see just how much you’re working with once your budget is stripped down. Cutting all non-essentials is the first part of that process.

Reevaluate Your Financial Goals

You don’t want to neglect saving long-term. It’s important to contribute regularly to your retirement, and you want to stay on track with your debt goals. But during an emergency, those goals need to be reevaluated. Why? Because if you don’t have money coming in, you’re using your emergency fund to pay for those goals. Do you want to keep paying off debt or saving for retirement? Or do you want to use as little of your emergency fund as possible? Your answer will affect your emergency budget.

Basically, you’ll have to decide whether to:

  1. Stay on track with your goals and replenish your emergency fund later, or ;
  2. Reduce your savings/debt goals or put them on hold until your income picks back up.

If you choose Option 1, you’ll simply stick to your goals and add them to your emergency budget. If you choose Option 2, simply adjust your emergency budget accordingly.

When it comes to savings goals, it probably makes sense to put them on hold while you’re in emergency mode. But debt goals are a little trickier, since you’re accumulating interest. To help you decide what to do about your debt goals in an emergency, consider some expert advice on emergency funds vs. debt payoff.

Some say it’s better to forget about an adequate emergency fund and tackle the high-interest debt first. If you agree, you might consider keeping your debt payoff goals intact, even if it means draining your emergency fund a little quicker. For example, here’s what You Need a Budget (YNAB) suggests:

When deciding how to best use available cash (including “buffer” money, new income, and even current spending), look through the lens of “risk of new interest expense.” Existing debt gives a 100% probability of interest expense, so it would be the primary focus of all available money, even at the expense of a smaller emergency fund…I’d maintain the smallest buffer required to allow me to sleep at night, then throw all other cash at that credit card debt.

In this case, you can reduce your debt payoff amount if your emergency fund gets to that “smallest buffer.”

On the other hand, Money Crashers suggests saving a bit more before tackling debt:

While paying off debt first helps your credit score and offers peace of mind, it doesn’t help during a financial crisis. If you put all your cash toward debt repayment, you won’t have anything saved up for a rainy day. Create a six- to eight-month emergency fund, which can help you in the event of a job loss, divorce, or illness. It also prevents you from going deeper into debt while dealing with an emergency.

If you like this advice better, you might go ahead and reduce your debt payoff while you’re in “emergency mode.” Consider this advice, then weigh it against the details of your own situation, including:

  • How much is in your emergency fund to begin with
  • How likely you are to drain it, and how long before that happens
  • How long before you have a steady stream of income

From there, come up with an “emergency budget” savings goal or debt payoff amount you’re comfortable with. Plan to pause or reduce any transfers or automatic payments while you’re in emergency mode.

Reduce Fixed Expenses

After looking at your non-essentials and financial goals, it’s time to review your necessities. These expenses are the same every month. Your cellphone bill, maybe. Your rent. Car registration.

These expenses are fixed, but that doesn’t mean they can’t be lowered. Make a list of your fixed necessities and see if you can find ways to reduce them. When I was in emergency mode, here’s how I did it:

Speaking of insurance rates, you might be tempted to cut back on insurance coverage when you’re in emergency mode. Maybe you’re thinking of ditching your comprehensive coverage, forgoing your renter’s insurance, etc. But keep in mind: when you’re in emergency mode, that’s when you need safety and security most. To me, this is when it makes the least sense to cut back on something like insurance coverage. Cut your fixed necessities, but don’t risk going without something that could make your emergency even worse.

Be Frugal With Variable Expenses

After checking out your fixed necessities, it’s time to tackle your variable ones. First, take a look at the necessities that vary in cost each month: your electric bill, groceries, and gas, for example.

Then, find ways to be frugal in each of these categories. I Heart Budgets recommends starting with food, which can vary quite a bit:

Reduce your food budget. I know, I know, this is not easy at all. But if you lost your job, you WILL find a way to remove $50 from your food budget, even if you don’t eat quite as healthy while you are dealing with this emergency. No sense in actually going hungry because you “needed” your organic pine nuts.

For other categories, you might find our bill-by-bill guide to be helpful. Here are some additional highlights for being frugal with variable necessities:

Electricity:

Gas:

Groceries:

These are just examples to get you started, of course. They won’t be possible for everyone in every situation.

Obviously, frugality is good whether you’re in emergency mode or not. But this is the time to re-evaluate all the frugal practices you passed on before because they were too inconvenient, or because you had enough money to skip them. When you’re in emergency mode, convenience has to go out the window. Cut back on your variable necessities as much as you can. If frugality is new to you, here are some basics.

Even if you’re drafting this budget before an actual emergency, it helps to simply know which categories are variable, and what frugal options are realistic should an emergency hit.

Strategically Rebuild from Your Skeleton Budget

After you’ve got your budget as bare bones as possible, look at the numbers. After cutting luxuries, exercising frugality and reducing the cost of necessities, what’s your monthly spending? That’s the number you’ll have to pull from your fund each month you’re in emergency-mode.

You know your own habits and situation. While I prefer to cut all non-essentials during emergency mode, you might feel comfortable keeping a few small luxuries in your budget. In that case, consider how much you’re comfortable adding back in, based on how much you have saved for an emergency, and how long that emergency is likely to last. Or, wait until your situation improves a bit, then add them back in gradually.

Then, after the emergency is over, you can get back to where you were beforehand. After my emergency, I found a small stream of income in a side gig. From there, I started to rebuild my budget:

  • Found a small stream of income in a side gig
  • Replenished my emergency fund
  • Added back in a few of my “wants”
  • Started contributing to my savings again
  • Updated other budget categories as necessary
  • Added in more “wants” gradually, as my income stabilized

An emergency fund is a great relief when you need it. But you also want that money to last. If your emergency is long-term, or if you’re in a financial crisis longer than expected, it can help to have an emergency budget in place. Emergencies are stressful, and anything that can ease that stress will help you focus on getting back on your feet.

 

AccountingBuilding an Emergency Fund