Foundations: Building an Emergency Fund
The pandemic has shone a spotlight on a cornerstone of good financial health: everyone needs an Emergency Fund. With so much uncertainty around the economy, public health, and job security, it can be used as a safety net while navigating uneasy or risky situations.
An emergency fund is a readily available source of assets that can be used to help with financial dilemmas – both planned an unexpected – such as job loss, debilitating illness, a major home repair, or the purchase of a car. Because the assets in an emergency fund must be highly liquid – easily be converted into cash in a short amount of time – it should include only cash & cash equivalents (such as money market accounts or no-penalty certificates of deposit).
Quick tip: though highly liquid (easily bought and sold), publicly traded equities like stocks, ETFs, and mutual funds can fluctuate greatly in value from day-to-day or week-to-week. For that reason, equities should never be included in an emergency fund.
The ideal size of an emergency fund can be calculated as a multiple of required expenses like housing, taxes, groceries, and debt. (Not included are restaurants, bars, impulsive Amazon purchases and all the other stuff that requires a decision each time money is spent.) Individuals with reliable income separate from earned compensation (such as trust income, alimony or child support, investment income, or even a profitable side hustle) or married couples with both spouses earning reliable incomes should aim for an emergency fund equal to three times monthly required expenses. Everyone else should use six times monthly required expenses as the target size. This is especially important for self-employed and freelance workers.
Quick tip: For a quick and dirty calculation, look back on 6 months of bank and credit card statements to identify the total amount spent each month and write that number down. This will give an average of total monthly spending, including discretionary expenses (those that can be curtailed or eliminated if necessary). This number will higher than average required expenses – and therefore larger than absolutely necessary – but will provide an extra margin of error that may be the difference between ease and anxiety in a tough financial crisis.
Another use for an emergency fund is for ‘F-you money’, or the ability to confidently leave a bad situation without having a secure alternative lined up. It is a lot easier to look for a new job or walk away from a bad employer if you know that you can get by for the next 6 months without income!
An emergency fund can also act as a ‘reservoir’ for self-employed and freelance workers during the lean weeks or months between jobs. During those dry periods, the funds could be used to cover required essential expenses. Once work resumes, the ‘reservoir’ can be replenished with surplus income.
It may be obvious why a person would want an emergency fund and how it might be used, but who has an extra $5,000, $15,000, or $50,000 laying around?
Imagining that amount as a lump sum can be intimidating. Instead of wondering how to squeeze an extra thousand dollars out of your income each month, try thinking about it as a daily amount spread out over the next 6-12+ months.
For example, a target amount is $10,000 works out to $27.40 per day over the next 12 months. Even though it is the same amount of money as $833.33 per month, $27.40 per day feels like a more manageable number. Rarely does a person spend $800 without noticing it, but spending $30 at a restaurant or on some neat thing from Amazon is easy to overlook. If you can afford dinner delivery for a family of four, you can afford $27.40 per day for an emergency fund.
Spend some time with your bank and credit card statements to calculate how you much you would need to put aside each day to build up a significant emergency fund. I think you will be surprised at how easy it is and how little it impacts your quality of life.
Iseler Financial, LLC | Registered Investment Advisor | Durham NC