When it comes to giving yourself a total money make over, improving the way you allocate money, so that you free up money to build wealth, one important item that is frequently talked about is the role of the emergency fund.
For someone that started in a clean slate, educated in personal finance, this is something that you have started. Yet when I talked to many who have not venture to fixed up their messy finance situation, emergency fund is a very vague subject.
In this article, I will spend some time explaining
- How you should view your emergency fund
- What are some situations where you will need an emergency fund
- How much of an emergency fund you require
- How to get to that emergency fund
- Some advance thoughts about emergency fund
- How I implement my emergency fund
The Virtual Banker that you can Borrow from
Every dollar that you earn has a job, be it feeding you, making your life fun, growing more dollars or taking care of your weakness in planning.
Emergency fund is a stash of cash that you can call upon as if your life depends on it. This phrase might sound a little bit drastic but it does emphasize the extreme condition where by you need to call upon this stash of cash.
The best way to visualize this is as if your emergency cash is a virtual banker that you can depend upon. This virtual banker is always at your beck and call and unlike your credit cards, loan sharks or relatives, this banker loans you money with zero percent interest when you needed it the most.
Like a real life banker, how much you borrow, you have to return to the virtual banker. Unlike a real life banker, there is no government to bail the banker out should the banker lend to unworthy lenders ( talking about you here). If you do not return the money to the virtual banker, the money with the virtual banker depletes and you cannot lend from him again (good luck for your next crisis).
Suppose that you have build up a stash of $300 for any medical needs and that you have an emergency fund of $2000. You just realize that for your accident, you need $500 for your treatment. This is more than the allocated amount that you have build up for medical needs
With the emergency fund, you can temporary relieve yourself of this dilemma. You can ‘borrow’ $200 from your emergency fund to act as additional funding to your medical savings. You will thus have $500. With this $500 you can pay off your immediate medical bills.
When you borrow from your emergency funds, you will have to pay it back. Come next month during month 2, when you received your pay check, allocate $200 more to your emergency fund, or if you wish return this $200 over x number of months if cash flow is tight.
You will continue to channel $100 to your medical savings. Now that you are more aware that you would need more medical funding, you may want to allocate more to your medical savings.
Isn’t the emergency fund just like your savings? Why do you make it so complicated?
I explained the concept of emergency fund to folks and many of them cannot understand why do we need to separate this cash out of their full chunk of savings and make things complicated.
I see this as the failure to understand the job needed for their entire savings. Most of the time, you see your savings to be used for
- Your children’s future polytechnic and university fund
- Your retirement fund
- Your ‘spare’ cash for vacation
- Your ‘spare’ cash that you can choose to buy a car
- Your ‘spare’ cash should there be an emergency
- Your cash for fine dining
- Your cash to buy clothes
If you look at your savings this way, try to understand this question seriously: When there is an immediate need for cash, how much of this savings can you use, without resulting to a negative consequence to your other goals (if you even have map them out in the above example shown)?
If you can answer that question confidently, then you have already map out your emergency funds. We don’t have to be anal in creating an embroidered chest to put your emergency funds.
Emergency funds is a systematic compartmentalization of your net worth, with a clear objective to take the role of a virtual banker in dire situation.
A Trigger List of Emergencies
What are events that constitute as emergencies? This will differ from person to person. However, in my opinion, all emergencies have one thing in common:
They are either known unknowns or unknown unknowns.
Known unknowns are variations from normal situation,or shocks to your plan that have occurred before in your life, but you can’t remember them (because in reality, who keeps track of a list of your failures or embarrassment in life)
Unknown unknowns are somewhat similar to the above, in that, they are variations from normal situation, or shocks to your plan, but they are events that you have not encountered or would only be known to people that does this kind of expert risk planning.
In most cases, Known unknowns are weaknesses in memory while Unknown unknowns are weakness in your planning competency.
Here is a trigger list of emergencies that may jog your memory and make you reflect if its applicable to you.
A huge hospital operation or treatment. You may have planned well to have a comprehensive hospital and surgical plan and critical illness plan.
However, the hospital policy in the country may require you to pay the hospitalization costs upfront first, before you can claim it later. The amount can be $20,000, $40,000 or $100,000. The social security savings plan might offset the smaller bills but if you choose to say in a private hospital, the limits might eventually mean you have to have an emergency fund to pay for a large hospital bill upfront before you can claim it. (Some case studies here, here)
Bursting of your shopping budget. You just started on budgeting and have allocated a sum of $500 per month to be spend on shopping. The rest of your disposable income have been allocated nicely to other areas in life. You didn’t watch your budget closely and end up spending $700 for this month on shopping. Since all your monthly budget is allocated nicely, the extra $200 will have to come from somewhere.
The expenses before disability income. Before you can claim disability income, there is a waiting period of 30,60 or 90 days depending on which disability income insurance you take up. When you are unable to work, the house hold expenses will have to come from somewhere.
You didn’t realize you have an annual insurance premium. You did well to plan out your monthly budget, allocating everything nicely based on what you spend on a monthly basis. Then suddenly you realize during the year end, that you need to pay $1500 in a one time insurance premium. This just threw your budget into a funk. How are you going to squeeze $1500 out suddenly? You are starting to have less faith in your budget….
Gifts, Gifts and more Gifts. Every time you will received an invitation of a wedding, farewell present, birthday and housewarming party.They are so hard to forecast and always comes when you least expected.
Forced to go on a last minute trip with girlfriend’s family. You already went for an overseas trip with your girlfriend when she mentions that the family invites you to go for a family trip with them. Its hard to say no and since this is a girl that you are going to marry, this means your expenses on this trip is not going to be normal. Where will this money come from?
Someone broke into your car. You woke up one morning and realize to your horror someone shatter the windscreen of your car. The car is not drivable in this state. You need to make a repair. Where is the money going to come from?
You lost your job. This is common. You got laid off and the times are bad, you might take 8 to 10 months to find a new job. How are you going to settle the family expenses during this period?
How much in your emergency fund is enough?
I realize (and probably you too) that different emergency have different severity and probabilities.
The simple answer given by financial planner is to have 3 to 6 month of your living expenses as emergency funds.
The problem is that this sum looks so daunting especially for folks new to personal finance that is trying to make end meets. They probably are so put off by the figure, but doesn’t realize that even a little bit allocated to emergency funds can be very helpful.
My answer to this is: have adequate.
It is more important to understand the nature and magnitude of emergencies that your fund can withstand and to save up more to get to a state where you can be comfortable with.
A good set of emergency fund target can be as such:
- $500: Your initial sum of emergency funds. This helps you resolve budgeting problems when you spend too much, mostly due to yourself still learning the right level to allocate to various categories
- $1000: This sum should cover a sizeable portion of your expenses and much monthly emergencies. This should be built up before paying down your debts, so that in the event of emergencies you do not need to borrow again.
- 1 month living expenses: This is where you would like to reach, where you can effectively live on your last month’s income. So you will spend last month’s income, then this month’s income will be use to buffer this month’s spending, with majority of your income allocated to next month’s spending
- 3 months living expenses: By the time you reach this stage, you have achieve what the text books have recommended. This should take care of smaller unemployment, usually during an unsatisfactory job position in a good job market.
- 6 months of living expenses or 3 months of disposable income: This level should buffer you against a prolong unemployment in a down market. However, in certain countries, it may be more difficult to find a job within this time frame.
- 1 year worth of living expenses: By this point you will have ample buffer to take most emergency within your stride even some of those living expenses and relative emergency hospitalization. At this point you might even be able to simulate whether your family can quit your job and live off your income generated by investments
Emergency funds is important, but even when the sum is small, they can be vital in helping you organize your financial situation well. Its important not to give up even if its difficult to build up to 1 month of living expenses.
How to build up your emergency fund
When you start off with debts, aspirations of building wealth, and wanting to get your financial house in order, how should you sequence these goals.
Do you want to do all three things at once or fulfil one goal at a time?
Doing all three things at once will get you there, you will see your three categories slowly build up, or pay off. However, some folks might feel more motivated to finish paying debts first.
My advice: understand these three item’s importance, how much you want them, your own motivation, determination level and come up with your own way.
There is no one size fits all.
However, I have some recommendations.
For the first month when you start work, or when you want to get your house in order, don’t pay off the majority of your debt. Pay the minimum. At the same time, don’t put any amount to wealth building.
The rationale is that, it does not make much of a difference if you delay your wealth building or paying off debts by 1 month (unless your debts is from loan shark and the interest is 20% per month!). However, you gain a notable magnitude of flexibility if you manage to build up a small emergency fund.
To buy into this personal finance helps reshape you world and to improve your life, you have to stick to it, and I see this emergency fund to be integral to it.
Imagine you overspend, makes some mistakes in the early stage of your budgeting, the only way you can gain flexibility is through credit card borrowing.
This is going to put a dent to your confidence.
- Cut your expenses,pay minimum on your debt financing, take on a little bit more jobs to free up $500 for your first emergency fund.
- For the next 1 year, put away $40 per month, to build up another $500 so that your emergency funds grow to $1000. Target is to clear your debts by channelling more to pay down your debts.
- When it comes time to collect your bonus, before spending, look to see if you can free up another $1000-$2000 to emergency funds, or even 1 month of your normal monthly salary. We cannot find a better opportunity to gain a sizable amount of money without affecting your monthly expenses constraint
- Look to see if you can up the monthly build up of emergency fund to $80 per month
In this way it is possible to build up roughly $6000 or 3-4 months of your expenses as emergency funds.After this you can continue to fund $80 per month so that yearly your emergency fund will slowly build up to $10,000 at least in 10 years.
Some advance thoughts with regards to emergency funds
If its listed here as an emergency, then its not really an emergency at all
What do I mean by this. If you look at the trigger list of emergencies that I provided, if I highlighted them, and you agree that at some point you will have to spend that amount of money, that means you should be able to plan early for them.
If you plan early for them, then you should not be using your emergency funds for them.
Take the case of car maintenance. The reason it may be an emergency is because, you look at maintenance that you have to pay yearly as a shock to your pre-planned money allocation. Since we mentioned it in this article, you know that it is something that you have to pay, and should have allocated a yearly figure for it.
When you allocated prudently to pay for the car maintenance, this isn’t an emergency at all.
The real emergencies are the unknown unknowns. These are the events that, if you sit down and think about it, even after 1 to 2 years of experience looking after your family expenses, and couldn’t think of anything else, then these are the unknown unknowns.
As you get better, you will have less emergencies
The majority of the emergencies that you encounter are likely to be known unknowns that, you know what they are, but you seldom look at them as part of your budget. This is usually because you start picking up being serious in managing your family’s finances.
As you get better, you should have less emergencies. And that is a good place to be. Less unpleasant surprises while you are living life.
Where should you store your emergency fund
If we are talking about an emergency we may want it to be as liquid as possible. However, having said that, if your emergency fund is $20,000, I doubt you will want it to be in a biscuit tin in your cupboard. Imagine if your mom or yourself accidentally forgot about it and throw it away.
Some people have the tendency to like to create ‘secret stash of money’ such as cut out a book to put cash in the middle. I like the innovative idea and while it encourages thinking out of the box, its kind of a pain tracking your emergency cash all over the place.
My recommendation is to open a bank account and do an automatic transfer instruction to this account for your emergency fund. Its easy this way to have a quick glance how much of a safety margin you have.
Should you take risk with your emergency fund
There are some folks who just cannot stand the thought of their emergency fund being idle. They want the law of compounding to apply to all their money so they put their emergency fund in some equities fund, high yielding fund or even a real estate investment trust.
The danger here is that, you do not know when emergency will occur (hence the term emergency) and when they happen you want to be able to count on the funds instead of receiving a double shock that, you didn’t plan for the emergency or you overlooked it, but also that your emergency fund is less than desirable.
Some folks would split their emergency fund into 2 portions, one portion that is just adequate to cover 75% of the most likely emergency and the second portion in something higher yielding.
My recommendation is not to be too risky with it. At most, put it in a higher yielding savings instrument such as a money market fund.
Relying on cash flow instead of emergency fund
The concept of an emergency fund is a way to compartmentalize a section of your wealth to use for emergency. We acknowledge that when it comes to processing various challenging issues with life, it makes use difficult to compartmentalize so we make use of bank accounts to physically separate.
However, if you have develop a great wealth building system such that it generates a consistent monthly or quarterly cash flow, you may be able to ‘borrow’ from any part of your wealth for emergency purchase, and ‘return’ them when you get your next pay check.
The crucial factor here is that you have a good understanding how this emergency fund works, and that you don’t have to be so rigid about how you separate money out as an emergency fund.
My past experience with an emergency fund
I should say that I am rather lucky in that I was able to grasp this concept before I started work. When I started, I did not use a physical bank account to separate the emergency fund portion from the rest.
I use a software call Quicken which allows me to box out how much can I tap for emergencies.
Since my only debt is to pay back my parents for the education loan and that I was able to channel $500 per month to my wealth building, I can slowly build up my emergency fund.
I actually called my emergency fund a less drastic name. I called it Buffer Fund, since it is suppose to buffer for anything unplanned.
If I have no idea what to do with the money, I will throw it there. So a lot of my allowances and one off bonus from work is stored there.
I took almost 3 to 4 years to build up $20,000. Back then I have the idea that your emergency fund needs to be 3 to 6 months of your salary instead of living expenses.
That took forever. It looks like I will never amass it.
The last check I have at least twice that amount. Most people hate seeing so much money sitting idle. However, I am rather passive over it, until recently, when I decide to do something about it.
I would likely leave $30,000 around and the rest of it will divert it elsewhere.
Emergency Fund is a topic that, I thought its easy to grasp, but as it turns out, its because I read up on it and are exposed to it. When you are not exposed to it, you view the world differently. I find that I cannot go back to the world where this kind of mental money compartmentalization doesn’t exist because of the benefits it brings.
You don’t have to be rather anal about it. If you have much savings, mentally calculate if you need to spend on the most drastic form of emergencies, how much do you have for that? That is your level of emergency fund.
I find that the bonus is the best place to target, but also the first month of working, since you are still in the student mode, your spending pattern have not been ‘tainted’ and thus you may find it easier to pull out $1000 to $2000 for an emergency fund.
Share with me what is your frustration with creating your emergency fund, where you put your emergency fund, or you think this is an overrated concept at all.