Goal Deep Dive: Emergency Fund
How much is enough?
Money doesn’t buy happiness, but it sure solves a lot of problems, reduces stress and gives people a chance to live a more fulfilling life. This post will answer the question of “How much money do I need?” by doing a deep dive into one of the top personal goals you should consider stealing, one of the most important investments you can make in your own mental health, and the top of the list for order of investing; your Emergency Fund.
Savings rates in the US are pitiful, on average people save less than 5% of what they earn. We have morphed into a nation of buyers. Partially that’s because we are bombarded by ads enticing us to buy crap we don’t need and partially because people have not educated themselves on saving and investing. We need less YOLO and more FOMO. FOMO for life where we are in financial control. We know about the dopamine released when we buy and feel momentary happiness which dissolves almost immediately but what about the much more important and lasting happiness we have from knowing we could buy whatever we want but flexing our discipline muscles by NOT BUYING?
Here’s a good thought exercise. Let’s say your take home pay is $100k. If you spend all of that you will have saved nothing for retirement and will be totally dependent on the government if and when you retire. Not a good place to end up. But what if you spend $80k? That means for each year worked, you save 1/4 of what you spend in a year which, if we ignore compounding entirely, means each year of work buys you 3 months of life without the need to work. What if you really flexed your savings muscles and only spent $50k in a year? That means every year you work, you earn enough to fund 2 years of your life. Let that sink in. By spending less you could take every other year OFF. Can you imagine how many opportunities this would open up in your life? Now ask yourself, would you rather work 40 years and buy whatever you want along the way or work 20 years buying only what you need then enjoy 20 years off? Ironically, if you learn to save, its very likely you will quickly be able to buy much more than you ever could have as a spender. This does require that you learn how to save and the first step to saving is creating an Emergency Fund.
“There is no bad weather, only bad clothing.”
I love the quote above because its a great metaphor for an Emergency Fund. Let’s say you’re caught in a winter storm and happen to be wearing shorts, a t-shirt and flip flops. You’re hosed and feel every bit of the pain. You don’t have any type of buffer to weather the storm and you suffer immensely. Actually, even a slight dip in temperature is very uncomfortable for you and will make you miserable. On the opposite end of the spectrum is the person who has thick socks and boots, a parka, insulated performance gloves and are actually feeling a little toasty because this storm doesn’t come close to upsetting them. They have the buffer needed to weather any storm. Life is full of storms, some mild, some massive, some that will literally tear your house down. Each of us is responsible to make sure we can financially weather those storms when they inevitably appear.
The Key to Weathering Financial Storms
A few years ago I jotted down a cheat sheet1 I keep in my journal and rewrite in each new journal. I refer to this cheat sheet for the order in which one should save assuming no high interest debt. I’ve used this to keep me on track and sending money where the payoff is highest which is why its important to note that if you have credit card debt or a high interest car loan, PAY THOSE OFF FIRST! If you put money in the bank at 4% interest and carry a balance with your credit card company at 22% interest, you will always be in debt. That is a downward death spiral.
By following the savings cheat sheet below and thereby building the savings discipline and muscle which starts with your Emergency Fund, you be on your way to financial independence. I’ll go into greater detail for each item on the cheat sheet next week, for now we’ll focus on the Emergency Fund.
Savings Cheat Sheet:
Emergency Fund
401k. Max it out
Health Savings Account. Max it out
Individual Retirement Account (IRA). Max it out
401k. Max out non-matched portion
Index Fund(s). As much as you can afford
529s (if you have kids). As much as you can afford
Pay off mortgage
Everyone post-school should have an emergency fund (E-fund) regardless of age. If you are fresh out of high school or college, you are excused if you don’t yet have an E-fund but for anyone who has been working for more than a year, if you haven’t saved anything, you should take a hard look at where your money is going and set your sites on getting your financial situation under control. Will you be in flip flops when the winter freeze hits or will your parka be ready?
Emergency Fund Levels
While the exact amount of an E-fund that brings optimum peace of mind will vary from person to person, my opinion is that in general, people should try to work up to having at least 1 years’ worth of living expenses they can access at any time such as an interest paying savings account. When you have this amount, life can throw almost anything at you and you can handle it. No matter what the market does, what happens with your job, your car, your living situation, you can solve the problem and move on without financial ruin or dire consequences. When you have this much money in the bank, the emotional benefits are amazing! You may think you need to be a millionaire to be rich but mentally and emotionally, you just need 1 year of money in the bank to first experience the feeling of being rich.
Here are the stages of building an E-fund:
No E-fund.
The storm comes and you’re in flip flops and a t-shirt. You are miserable.
You are broke and feel that way constantly. Money rules your life, you are its slave. Losing your job would be devastating. You work because you have to even if you hate what you do. You are jealous about what other people can afford and may splurge here and there because “you deserve it” which only keeps you where you are. Any issue is a huge issue and causes major stress and anguish. You likely feel helpless and are more likely to have a victim mentality. Sadly, more than 1/3 of Americans are in this group and even 20% of those making over $150k/yr which goes to show that income doesn’t necessarily mean savings. If you are don’t have an E-fund and are living paycheck to paycheck, look for every possible way to cut costs so you can start saving.
1-month E-fund.
You have jeans and a light jacket, you can handle small changes in the weather.
You’re feeling pretty good, you can weather many small life events but a big expense or losing your job will set you back. You need your job more than it needs you. Things feel expensive but you know you could afford them if you really wanted. You are beginning to build your financial muscle and it feels strange. If you’ve never had this much money saved, you might suffer from impostor syndrome and feel like you need to spend. If you can save 1 month, you can build a bigger nest egg, keep going. Treat this money as untouchable.
3-month E-fund.
You have a rain coat, a few layers and gloves. It takes a pretty big storm to make you uncomfortable.
Three months of your monthly expenses saved means you can deal with just about anything that comes your way without going into debt. You can afford to move, switch jobs, pay for car maintenance, resolve many health issues and take fun trips here and there without depleting your savings. If you’ve never had this much money in the bank, you will likely be expecting something bad to happen to wipe you out or are starting to feel a yearning to spend or invest in one of the many opportunities that are coming your way. Don’t do that. Keep your fund in place, the storm will come one day but you will be ready. Enjoy having peace of mind for perhaps the first time in your life.
If you are single and without kids, I’d say you should always keep at least 3 months of an E-fund. Let’s say you spend $5k/mo, this means you have $15k in the bank. At 4% interest, you’ll earn $600/yr or $50/mo interest, take yourself out for a simple meal each month to celebrate your financial muscle but don’t touch your principle.
You are not bulletproof. Losing a job would wipe out your nest egg. Since it can take several months to find a good new job, losing your job represents a very real risk and you will feel beholden to your job but most other day to day financial stressors are now minimized.
Once you have 3 months saved in an Emergency fund, you should begin saving for retirement while continuing to grow your E-fund. Definitely max out any company 401k match.
4. 6-month E-fund.
You have a parka, big gloves, a fleece lined beanie, insulated pants and boots. This isn’t really a storm, its more of a windy day that will soon pass.
Feels great doesn’t it? You have enough money to live half a year without going into debt or calling anyone for help. You could likely tighten your belt if you had to and last an extra month or two. You can more boldly request a raise at work and afford to take a trip with your time off. Look at your line of work, would you be able to get another job at the same income level before running out of money? If not, you should definitely keep saving.
If you have kids, I’d say a 6-month E-fund is your minimum goal. If you don’t have kids and could easily get another job, once you have 6 months saved, you should begin working your way down the cheat sheet above.
5. 1-year E-fund.
You have all the warm gear needed plus blankets and wood to make a cozy fire. Shoot, you can even invite over some less-fortunate friends to enjoy s’mores by your fire!
With 1 year of expenses in the bank you can handle pretty much everything. If you lose your job you have time to find another good job rather than taking anything you can get. Using our hypothetical $50k spending per year, this means you have $50k in the bank and are well on your way to having enough saved for a down payment on a house. At 4% interest, you’ll earn ~$150/month interest which probably covers 1 decent visit to the grocery store each month. Your money is now working for you instead of you working for money. You’ve set in motion the first line item for earning passive income, the key to a well-funded retirement.
This is your goal in general and you will feel much more comfortable with this amount if you have kids. I’d consider this financial enlightenment so its not surprising that only 16% of people reach this heightened state of savings.
The mental health benefits of having 1 years’ worth of living costs in the bank are hard to fathom if you’ve never experienced the feeling! Imagine having the money to buy a new car, a boat or pay for an around the world trip in cash!!! You could and it feels great to know that you could, but you don’t because you’ve built up the discipline and financial muscle to know that being able to do almost anything you want is EVEN BETTER than actually doing any one of those things.
When you have this much saved, you feel in control of your life and realize that most “problems” are mere annoyances. You sleep a little bit better. You dream bigger dreams. You can jump on great opportunities. You work because you want to not because you have to, since you can take a year off whenever you want. You no longer have to put up with an insufferable boss or live somewhere you don’t want to live. You have become an expert at saying no to things you want but don’t need. You have financial muscle and are well on your way to retiring early.
How to use credit cards in your E-fund?
Some people consider their credit cards their emergency fund. This is a big, huge, stupid, mistake that helps credit card companies make billions while you stay poor! If you can’t pay your credit cards off monthly, you are spending more than you earn and then making it even worse by literally paying over 20% extra for everything you buy. Why would you piss your money away like that? Why would you work an extra 20% just to pay credit card fees? Credit cards should only be used if you can pay them off at the end of each month. Until you have 6 months of savings between your E-fund + money in step 6, taxable investment account, don’t fool yourself into thinking credit cards are a good strategy for an emergency fund. However, once you have 6 months of savings or savings + money in a taxable investment account (which you could sell at any point if you had to), its fine to think of credit cards as a backstop since the probability is quite low that you would need them.
How much is enough?
The exact dollar amount one should have in their Emergency Fund is different for everyone and is completely dependent on your spending. The lower your spending, the less you need. If you don’t know what you spend in a month, keep a daily log.
Look around at the stuff you have and think about how you use your life to earn money and use that money to buy stuff. The cost of stuff adds up quickly in time worked. Consider how much happiness your spending brings you vs the peace of mind and financial freedom its costing you and try to separate wants vs needs. The more you can reduce spending on wants, and the better you are at fighting off the consumer-mentality the quicker you’ll get to the point where you could buy whatever you want.
If you follow the stages for building an Emergency Fund outlined above, you will slowly but surely build the mental and emotional fortitude to accumulate wealth at a level you never believed possible and will be able to handle anything that comes your way.
What stage are you in with your Emergency Fund?
Have you needed to dip into your emergency fund recently? If so, how come?
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For further reading on how we convert our life into stuff, check out a life-changing book, the OG, the one that will help give you the mental fortitude you need in those consumer moments of weakness; Your Money or Your Life. If you buy through the link, I’ll get a small commission at no additional cost to you. The book is also available for free at most libraries although you’ll likely want your own copy to scribble notes throughout.
My original inspiration for the Savings Cheat Sheet came from Dave Ramsey’s Total Money Makeover. An excellent book for those who are at the beginning of their journey into understanding personal finance.