Debt Guide – Step 3 – Create an Emergency Fund


Prerequisites

This step can be done anytime. So you should do it NOW! That being said, it’s a lot easier to do this step once you have a budget in place.

What Is It

An emergency fund is for when things go wrong. It’s what keeps people that live paycheck to paycheck from becoming homeless if they lose their job. It’s an extra stash of cash for emergencies, of course.

Action

  1. Open a new free savings account (or a cheap one if you live in a country where free bank accounts don’t exist). Your emergency fund will go here. Keeping it separate from your other accounts makes it easier to not accidentally spend the money.
  2. Make sure that when your job pays you, they’re automatically depositing money into your checking account (instead of handing you a check every month).
  3. Set up an automatic transfer for four days after your payday to transfer $100 into your emergency fund savings account.

The goal is to save at least $1,000 before moving on to the next step.

When To Use It

You can tell whether you should use your emergency stash really easily. Just ask yourself these two questions before spending.

  • Is it unexpected?
  • Is it urgent?

The answer better be “yes” to both of those if you’re going to spend that emergency money! A broken washing machine is an emergency. A broken refrigerator is an emergency. A broken XBox is not! (It’s not urgent).

When You’re Done

  • You have at least $1,000 in a savings account for emergencies.
    • Note: If your emergency fund falls below $1,000 while you’re on a different step, stop everything else you’re doing and add money back into the emergency fund until you have $1,000 again. This minimum is essential.
  • You have a separate savings account specifically for your emergency fund.
  • You have an automatic transfer setup to go into your emergency fund account.

When To Stop

Although the “When You’re Done” section requires at least $1,000 before moving on, this is an ongoing process. Once you get $1,000, your emergency fund will continue to grow because of the automatic transfers. As such, it’s important to know when you can safely stop transferring money in.

To determine how much money you need in your emergency fund, just look at your budget. Take how much you spend on average in one month and multiply by 3. That is your minimum amount. You can fret, worry, and discuss about whether you should save 3 months worth of expenses or 6 months worth, but it’s a very personal choice. Here are some things you can consider when deciding how much is enough for your emergency fund.

  • How long could it take you to find a new job if you were let go today without warning?
    • If it could take a while then a larger cushion is better.
  • If you lost your job, would you immediately cancel your cable, stop eating out, and halt all unnecessary purchases until you found a new one (would your spouse/significant other do the same)?
  • If you miss a mortgage payment will you lose your house? 6 months is better if so.
  • Are you paid irregularly? Contract workers and temporary employees (for example) should have a 6 month cushion.

While you can have every good intention to immediately cancel all extraneous expenses like subscriptions, lawn care, and eating out if you lose your job, few people do. Most people simply keep living the same way as before right up to the day they get an eviction notice, or have their water turned off, or get evicted from their home. For this reason also, it’s better for everyone to have a bigger cushion.

Potential Issues

If your emergency fund is not growing regularly then there are issues that need to be addressed. You can solve the problem by reassessing what is happening with the emergencies that have been going on. Ask yourself whether anything similar may come up in the future, whether they were true emergencies, and if they can be budgeted for. In my experience emergencies don’t happen very open – perhaps twice a year at most. You can also raise the amount going in to your “Unexpected Expenses” category every month to mitigate this issue. Make sure you’re planning for things that are likely to break in your budget. Cars, computers, and washing machines don’t last forever – they all need extra money budgeted for them every month to prepare for when they will need to be repaired or replaced. The same goes for doctor visits, because your body needs checkups now and then as well.

Extra Credit

At $100 per month it will take you 10 months just to get out of this step! Your extra credit is to find some extra cash and add it to your emergency fund. This can come from anywhere and you’ll probably see some likely candidate categories in you budget. You can also sell stuff you don’t need or find some work on the side. The next section offers more ideas.


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