January 20, 2017
Introduction
When you’re living paycheck to paycheck or you’re one unexpected expense away from not being able to eat, you may wonder where all your money went, not to mention, wishing you had more of it.
Budgeting will help you answer the question “Where is all my money going?”, which will put you on the path to saving more of your income.
Your emergency fund is the baseline that your bank account never dips below; that is your zero. The emergency fund is money for you to live on if the worst case scenario occurs. If your emergency fund is $10,000 and your bank account has $12,000 in it, you only have $2,000 available to you for spending or investing, not $12,000.
“But I have $12,000, I want to spend it all!” you say. No! You do not get to spend the money in your emergency fund, unless it’s an emergency. An emergency fund is not for things of want, it’s for needs that you cannot live without and the rest of your money has been used. This fund will be there for you when you lose your job, have unexpected medical needs, etc, etc.
How big of an emergency fund do I need? The size of your emergency fund depends on your monthly expenses. What expenses can you not get out of paying if you lost your job and had no income? You need to pay your rent/mortgage. Do you have a car payment? Do you need gas for your car or money for public transit? You’ll need food to eat. What kind of food do you want to live on in your worst financial hardship? Ramen and hot dogs may be cheap, but unhealthy eating can lead to expensive medical bills.
Use your budget to help you determine the recurring monthly expenses you need. Next, determine if you were to lose your job, how long would it take for you to find a replacement for the lost income. Typically, emergency funds range 3-12 months, with three being the bare minimum and growing to 12 in cases where people may feel great anxiety over a lowering balance of their emergency fund, working in a field with limited openings, aren’t sure where to invest extra cash, or they have a large surplus of disposable income. At the very least have three months worth of expenses in your emergency fund, slowly working beyond that as you continue maxing out your investment vehicles. You do not need an emergency fund larger than 12 months; the extra money can be put towards investments.
Where do I keep my emergency fund?
Speaking of investments, you’ve now got a considerable amount of cash sitting idle and not working to earn more money. You’d like to know “What can I do with idle cash to earn the most interest?” Great question! Currently, your best bet is to keep your emergency fund in an online savings account earning the highest interest rate you can find. Most likely, this will be in the form of a savings account.
Savings accounts may allow for a higher return on idle cash, but there are limits to how many transfers can be made to the account each month. At the time of writing, the limit is six. This means that a bank can charge you fees for every transaction over the limit AND they can even cancel your account. This is not the bank’s fault, they are following the law. If the bank does close your account, they will mail you a check with the remaining balance.
A checking account will allow you to make as many transactions as your heart desires, but typically pays a fraction of the interest. A hack to earning more interest on a checking account is to keep more money in the account. For example, at Ally Bank, a checking account with less than a $15,000 balance earns 0.10% interest, but an account with a balance of $15,000 or more earns 0.60% interest, which is a huge difference over time. However, a savings account with Ally earns 1.00% regardless of the balance.
Another option is to rotate your money into a Certificate of Deposit, more commonly referred to as a CD. CD’s are available in varying amounts of time. Ally offers CD’s from 3 months to 5 years. Currently, a CD is going to earn you very little interest and it’s better to just keep your money in the savings account, because the money is liquid. A CD will hold onto your money for as long the time frame selected and leaving early results in a penalty, robbing you of your interest. If you choose to go the route of CD’s, it’s nice to have them done on a rolling basis, so you constantly have money coming back to you, rather than having it all tied up in CD’s.
Extending the length of your emergency fund When you’re in dire times of need and you are struggling to replace your income, look for expenses to cut. This is a great way to prolong the length of your emergency fund and you can continue to pay your necessary bills. Simple ways to make it last would be cutting the cord on your FiOS service or selling your car to eliminate monthly payments and purchasing a reliable, cheaper car in cash.
The biggest benefit of having an emergency fund, besides having it there when you need it, is the peace of mind it brings. This is a little piece of what Financial Independence (FI) feels like. If you lose your job, you’ll be disappointed, but you don’t have to worry or feel the anxiety of not having that money in the event of an emergency.
Besides the lower blood pressure, your emergency fund will also save you from needing to take on bad debt. You won’t have to rack up tons of credit card debt, just to make ends meet. Paying off loans with higher than 20% interest rates isn’t how you want to spend the next 10 years. Prevent this backsliding. Establish an emergency fund.
Remember, your emergency fund’s purpose is to save your ass from unexpected shortages of cash or unpredictable needs for money, such as medical emergencies or loss of employment. Keep a minimum of three month’s expenses in a high interest savings account and don’t touch it unless you absolutely have to. Build up a small emergency fund, while paying off debt, and increase it as you begin investing towards the long-term. Ignore that your emergency fund exists, but enjoy the peace of mind it provides as you set your life on FIRE becoming financially independent and retire early.
How long will your emergency fund last? Let us know or ask questions in the comments below!