Wouldn’t it be great if everything in life always went exactly as planned? Unfortunately, life doesn’t work that way. We can plan out every detail, but often there are bumps in the road. When life throws you a curve ball, make sure you’re ready with a financial emergency fund. This is an essential part of a financial plan to get you through your roughest patches.
First, what is an emergency fund?
An emergency fund is money that is set aside for the sole purpose of providing you with an income in the event that your current income stream dries up. Imagine that tomorrow you’re given a layoff notice from your job, or news breaks that your company has gone bankrupt. While you can certainly find another job, it could possibly take a number of months until another reliable flow of cheques are headed your way. In a properly constructed financial plan, you’ll have an emergency fund that will float you safely through those months.
What an emergency fund is not
You should never think of an emergency fund as a way to cover unexpected medical bills or to replace your income in the event of a serious illness that ruins your career. This is what critical illness insurance is for (another critical part of a strong financial plan). It also should not replace your (or your spouse’s) income in the event that you pass away. Again, life insurance exists for this purpose. Your emergency fund is for short term income problems, like losing a job, not for long term or permanent problems like death or critical illness.
How big should an emergency fund be?
There are two common strategies in building an emergency fund. I’ll discuss both of them and talk about the pros and cons of each.
The first strategy is to build up enough money to continue your existing budget for about three months. If your current budget generally runs you about $5 000, then your emergency fund needs to be $15 000. Simple. The advantage of this type of emergency fund is that you don’t have to change anything about your standard of living. Everything you currently enjoy, you can continue to enjoy. The biggest disadvantage, is that it runs out quickly. Three months goes quickly, so you’ll need to really hustle and find a new job.
The second strategy is to trim your expenses only to the bare essentials and calculate how much you would need to survive for six months: rent/mortgage, utilities, food, and a small amount of gas in the car. All your discretionary spending should be suspended while this type of emergency fund is activated in order to drag out the fund as long as possible. The biggest advantage of this type of emergency fund is that it gives you a lot of time to land your new job. It is possible that if your company is going bankrupt, the overall economy is struggling, making it difficult to find a new job. Giving yourself a full six months to job hunt allows time for the economy to recover and for companies to start hiring again. It may also prevent you from panicking and taking a job you would hate, just to make ends meet. Obviously, the disadvantage to this style of fund is that you have to cut back. Your cable package should be cancelled (or at least downgraded), stop going to restaurants, and no new tech gadgets. But after all, this fund is for emergencies; should you really be booking a vacation in the midst of a financial crisis?
How to build your emergency fund
Now the fun part: how do we build this fund? The easiest way is to automate it. After you calculate how big your fund should be (using one of the two methods above), divide that number by the length of time you want it to take to establish your fund. I recommend it taking a maximum of two years to fully build your emergency fund. So if you calculate that you’ll need $10 000 in your emergency fund, divide that by 24 months, meaning you’ll need to set aside $417 per month. Most online banking accounts make it simple to set up automatic transfers from your primary account into a savings account that you can designate as your emergency fund. Set it up and forget about it. Obviously, if you already have the funds to make a lump sum deposit into your emergency fund, that would be ideal. The quicker you get it in place, the quicker you’re protected against an emergency.
When deciding which type of account to store your emergency fund in, keep liquidity in mind. You’ll need to be able to access your fund relatively easily and quickly in the case of an emergency (ie: high liquidity). Using a high volatility stock portfolio is a terrible idea for an emergency fund; the value could crash exactly at the time when you need to withdraw (especially if your layoff is due to a struggling economy).
That being said, having some growth and indexing could be advantageous for your emergency fund. The goal of an emergency fund is not growth or profitability, but it should be able to keep pace with the cost of living so that if it sits unused for a number of years, it’s still an appropriate size to serve its purpose of protecting your budget. Always consult with a professional financial advisor to pick the right account for your situation.
So get number crunching and start building your emergency fund. Your future self will thank you!