The Importance of an Emergency Fund
When it comes to crafting a financial plan from start to finish, it’s natural to be excited about setting goals, creating a plan, building a portfolio, and achieving our own version of financial freedom. These steps are fun and exciting, but first let’s make sure we have an emergency fund in place. Everybody, regardless of their financial standing, should have an emergency fund in place for when disaster strikes and we are left with little or no source of income. Let’s discuss the nuts and bolts of the emergency fund and why it may be important to have in place now more than ever.
The Purpose of an Emergency Fund
When talking about financial planning as a whole, emergency funds get discussed very little. They’re boring, certainly aren’t “glamorous,” and truthfully we hope they never serve their actual purpose. For these reasons, setting up and funding this account can be difficult to stay motivated about, but it’s step one in any basic or complex financial plan. It simply can’t be overlooked. What is the exact purpose of the emergency fund though, and why is it so important?
The emergency fund is put in place so that in the event that we were to lose our source of income, we would have some cash reserves that we could use as an alternative to withdrawing from retirement/investment accounts, borrowing money, etc. The goal is to be able to keep the same standard of living for 3-6 months while we recover from what ever hardship we’re facing (loss of employment, sidelining injury, etc.) While we hope to never need this cash, it should certainly be in place and updated often according to our monthly budget.
Creating the Emergency Fund
When setting up our emergency fund, it’s important to remember the purpose of our fund and create it accordingly. There are some common mistakes that people make which eliminate the purpose of the emergency fund in the first place, let’s avoid those mistakes and list the steps to starting our own emergency fund!
1) Open a separate savings account for our emergency fund
Often times, people want to just add to their existing checking/savings account with the idea that they’ll continually sustain 3-6 months of needed funds in this account at all times. The problem here is obvious, few people are disciplined enough to hold true to this method and the money gets spent. Instead, open a brand new account with the sole purpose being an emergency fund. Remember, this cash should literally be kept in this account forever. If we use our everyday checking/savings account it’s simply not going to work out.
2) Add our monthly expenses, don’t short ourselves
Another mistake that’s easy for one to make is that when they begin adding their monthly expenses, they often think “Eh I could live without this or that expense.” Don’t do this, we don’t want to short ourselves. The whole idea here is that we want to have enough cash built up to sustain the same life style we’re currently living. If we’re going to make a mistake, let’s over save in our emergency fund, not fall short.
If a time comes where we need to utilize our emergency fund, that’s when we can start cutting things out of our typical budget. At this point, yes we probably should get rid of Netflix and HBO Max. Maybe we shouldn’t go out to eat so often when we don’t have any source of income, but let’s make that decision ourselves when it comes time to use these funds.
Instead of shorting ourselves, add up every single dollar that we spend throughout the month, and don’t forget the little things that we don’t even realize we’re paying for. A good idea here is to look at last month’s bank statement. Look at every transaction and add them up for our total monthly expenses. While a lot of us have a monthly budget and we have a good understanding of our bottom line every month, I would still recommend using our bank statement in order to get an accurate figure. Again, don’t short ourselves, if we feel like we didn’t spend as much this month, look at previous months also, even add a couple hundred bucks at the end. It’s all about peace of mind.
3) Fund the account
Now that we have our account open and know our monthly expenses, it’s time to fund this account. Typically, it’s recommended that we fund enough for 3-6 months of living without income. In other words, multiply our monthly expenses by 3-6 and that’s our target account balance. How do we know how many months we should account for? That’s up to you. What makes you comfortable at night? Certainly 3 months at least, but if you can even imagine a scenario where you may be unemployed for any reason for 6 months, do yourself and your family a favor and prepare for the worst. The last thing we want to do is go into debt or drain our retirement accounts when disaster strikes. Fund the account month by month as fast as you can, or make a lump some payment into the account, and do not touch it! This money is for emergency purposes only. It shouldn’t be spent until we are in a true financial emergency, fund the account, and forget the money is even there.
4) Review our monthly spending and add to our emergency fund when needed
It’s common for people to set up their emergency fund, provide 3-6 months worth of cash into the account, and forget about it. While it’s great that we have it funded, it’s typical for our monthly expenditures to increase year after year. Have you ever heard of this thing called inflation? Have you added to the family or taken on a bigger mortgage? All these things should be reviewed at least once a year and accounted for in our emergency fund. It would be a disaster if the time came that we needed to tap into this account, and what we once thought was a lot of money now seems like pennies. Review your emergency fund yearly and update/add funds if necessary.
Wrapping Up
An emergency fund should be the foundation of any financial plan. Everyone should have an emergency fund in place before making any major financial decisions. Now is the time to take action if you don’t have an emergency fund. Set one up, fund it properly, and don’t short yourself. While we hope to never need these funds, peace of mind is priceless. The world moves fast and the unpredictable happens everyday, so prepare yourself financially. If you need any help with your emergency fund, or any aspect of your financial plan, don’t hesitate to ask! Getting financial help/advice doesn’t have to be complicated and certainly shouldn’t feel like a sales pitch. Call me today!
Tanner Millar
Investment Advisor - Core Planning
tanner@yourcoreplan.com
(660)-998-4639