The car won’t start. The water heater springs a leak. Your trick knee finally goes. There’s no way to know exactly which emergencies life will bring us, but one thing is sure: emergencies will come.
An emergency fund is table-stakes in the financial planning discussion – spoken-for cash that frees up other money you can use for investing and spending. But the reality is that 46% of Americans don’t have enough emergency cash on hand to cover three months of expenses. If there’s a medical emergency, maybe you could get on a payment plan, but what if you lose your job?
The most solid strategy is to build an emergency fund – accessible, ready and able to support you and your family when you hit a rough patch. Let’s look at a few essentials on creating and protecting your rainy-day money, and how this fits into your overall wealth plan.
How Much Should it Be?
Three to six months of expenses is the short answer for how much you should have in the fund, but the difference is in the details when it comes to the individual investor. As with many areas of finance, being too generic and dogmatic about the answers can get you into trouble.
Remember that your expenses depend on you, that’s why we don’t speak in dollar amounts. Obviously, a few months’ expenses will look different for you than your neighbor, depending on real estate, vehicles, medical needs and any number of differentiating factors.
Also keep in mind that we’re talking about expenses here, not income. So it’s not just the money you’re bringing in every month, and expenses typically means necessities – a roof over your head, food on the table and no bill collectors at the door. This may be a more achievable figure than it seems.
There are complicating factors as well. You should always lean toward six months of expenses, especially in a single-income house, as emergency funds are essential with loss of income. Another salary can give you a little more wiggle room.
Also, if you’re a business owner or partner, and your income affects others’ lives and not just your family, you’ll want to consider bulking your emergency fund up even further.
Earmark It!
Emergency funds can be remarkably tempting to spend, especially when you’re first putting one together. The first time you have $8,000 untouched sitting in an account, an impulse cruise for you and the family might start to sound like a good idea.
Less frivolous expenses can veer you off course as well. An updated vehicle with all the trimmings, a new roof before this one starts to leak, finally remodeling that bathroom you’ve always hated – there’s no shortage of “urgent” matters that will start pulling at that money. But keep the name in mind: emergency fund. It’s intended as a cushion during hard times – a last resort for when the rest of your accounts run dry.
Many banks now let you name your accounts, which can be a helpful mental trick. Brad Klontz, founder of the Financial Psychology Institute, writes: “Most of our decisions and motivations are housed in our emotional brains, not in our rational brains. That’s why abstract concepts, such as ‘savings account’ or ‘retirement’ are not very inspiring,”
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“Emergency Fund” might be a label with a bit more punch, and help you focus in on what that money is really for. Labeling ahead of time can help you stay away from that fund as well. You might not impulsively spend “Emergency” money on the wrong thing if the account next to it is labeled “Anniversary Island Vacation” or “Grandkids College Fund.”
Loaded for Bear (Market)
Beyond the wildcard emergencies in our own lives, from a bird’s eye view, the economy is uncertain. A quick Google search will bring you to countless predictions of a bear market – it’s been a long time, historically speaking, since a depression in the economy. When it comes to the bear market, it’s more of a “when” than an “if” question, and we need to be locked and loaded for it.
Job loss, layoffs, salary cuts – these are the kind of everyday long-term emergencies that make building an emergency fund so important. Life-threatening catastrophes might not seem very real to us, but most of us have at least one friend whose livelihood was threatened by the 2008 economic crisis.
Recency bias is the term for our human tendency to prioritize recent events over what happened before them when planning for the future. If the markets are generally up lately (which they are), then we tend to think that trend will continue. But there’s a lot of evidence pointing toward the larger trend saying something else. Building an emergency fund can help you feel – and actually be – prepared.
Guard and Grow
Keep in mind that you want your rainy-day fund liquid – you don’t want it tied into a real estate deal when you have an urgent medical bill. But if it’s too liquid, you might find it too tempting to spend it in non-emergency situations.
One step you can take to guard your fund and grow it a little at the same time is to put it in a high-yield savings account. You may get an interest rate of 2% or so, and you will have restrictions on how many withdrawals you can make per month, which can help keep you from making impulse buys.
You always want to save until it hurts a little. It’s like exercise – the sore muscles you have today make for better overall health tomorrow. It may pinch a little to forgo that latte or second pair of running shoes, but a healthy emergency fund will be worth it and will help you separate out money you can use for investing and spending.
Putting together a solid financial plan, not hoping for windfalls or rolling dice on the market, is the way to true wealth. Download our complimentary guide, “7 Secrets to Accumulating Your First Million” for concrete, down-to-earth tips on building your assets.