What do you do when the unforeseen happens? When "you know what" hits the fan and you're hit with a $2,000 bill out of left field. Or even worse, you get the notice that your company is downsizing and you are one of the employees getting let go. What happens next? Well, the answer for many people is not good. They usually go into debt or have to go to friends/family with their hat in hand asking for help to bail them out. If those don't sound like good options for you, then let's take a look at how to avoid falling into this trap.
Part five of our Financial New Year's Resolution Series is on the critically important emergency reserve. Some call it the "rainy day" fund, others call it the "what if" account but at the end of the day, the emergency fund is simply a cash account that you keep available at all times for the unexpected events in life. This account should be kept liquid at all times, meaning you have immediate access to this money at the drop of a hat. The emergency fund does not need to be invested in stocks or socked away in real estate. It should be kept in a savings account, ideally not your checking account, but a savings account that is electronically linked to your checking account so you can access it if need be. This is a fundamental aspect of building a strong financial foundation and is the first goal we set when helping someone with their financial planning. Whether they are 25 or 65, keeping an emergency fund is absolutely necessary!
The amount you hold in the emergency fund is very important. As a general rule of thumb, we recommend keeping 3 - 6 months of your living expenses in the emergency fund. So if you spend $5,000 per month on you basic living needs, then you'd need to keep $15,000 - $30,000 in a liquid savings account. There are a couple of reasons for this rule of thumb:
- If you lose your job, then it gives you 90-180 days to find a new one. This is much less stressful than having 2 weeks!
- In the event of a disability that prevents you from doing your job, your disability insurance will generally have an elimination period (equivalent to a deductible) before the policy starts to pay you. This elimination period is typically 3 - 6 months so your emergency fund will bridge this gap.
So, now that we know who needs an emergency fund (everyone!) and how much should be kept in the account we need to discuss how to get there. Honestly, at the end of the day, how we get there doesn't matter, just as long as we get there. But let's look at a couple of ideas you can plan specifically for your New Year's resolutions.
- Possibly the most extreme way is the Economic Shutdown! This is an exercise where you literally go into a spending freeze and only spend money on the bare essentials, saving every penny you can. We would recommend doing this for a defined (short) period of time like a month or two. You can get the inside scoop of what it's like in our E-Book!
- Systematically save each month into your emergency fund. You can actually adjust your payroll to send 5% (or whatever amount you're comfortable with) directly into a separate savings account so the income never hits your checking account. "Out of sight out of mind" is very powerful when it comes to saving and before you know it, you'll have your emergency built in no time!
- Don't splurge during bonus time. Sorry, this one may not be the most fun but take advantage of your annual bonus as a way to pump up that emergency fund. You'll certainly want to treat yourself to something nice. After all, you've worked hard to earn that bonus so go out to dinner or buy that new Apple Watch you've had your eye on. But don't blow it all on stuff you don't need. Your annual bonus can be a great way to catch up on savings goals.
- Use a cash back credit card. Now, it may seem odd to see this on a list about savings ideas but stick with it for a second. When used responsibly, credit cards can be a great resource. You shouldn't be carrying a balance, but if you pay it off each month, use a credit card that gives you cash back. At the end of the year when you get your cash reward, plow that cash directly into your emergency fund. This tip alone won't get you to emergency fund success, but it will be icing on the cake without doing any additional work.
Starting your emergency reserve can be difficult. Whether you've already built up an emergency fund or are just getting started, be sure to create your Wela account today and you can chat with one of our Wela advisors. You'll also be able to track your progress and learn about ways to build your wealth.
Suggested New Years Resolution:
I will defer _____(amount)_____ of my paycheck to a savings account. I will commit to an economic shutdown in _____(month)_____ and put the extra savings toward my emergency reserve.
Financial New Years Resolution Series: Part 1: Planning Your Resolutions – Where to Start Part 2: Organizing Your Finances Part 3: Creating A Budget Part 4: Pay Off Debt