Step 3: Save an Emergency Fund
The shortest period of time lies between the minute you put some money away for a rainy day and the unexpected arrival of rain.Jane Bryant Quinn
Wouldn’t it be awful if some random event came along and totally messed up your budget and forced you back into (deeper) debt? Something like a medical emergency, car repairs, losing your job for being caught reading a politically incorrect blog at work, legal fees because you get locked up in an Indonesian prison on trumped-up charges, an F-35 crashing into your house, etc. etc.
Well, here’s some bad news. As time passes, the probability of some such random, nasty event occurring approaches 100%. In other words, bad things do happen from time to time. It is not a risk. It is a certainty.
You’ve got to be ready.
A colleague recently needed car repairs that cost around $1,000. She complained that it was hard to scrape up the money. She had to cancel a planned trip and she ended up borrowing some of the total from her mum.
This is my colleague I’m talking about. Someone who has an income comparable to mine. Not a huge amount of money, but plenty. I wouldn’t say this to her face, but if you’re a gainfully employed adult who can’t easily afford a random $1,000 expense that comes out of the blue, you are irresponsible. You have to be liquid enough to manage the various, minor vagaries of life. Such an expense should be annoying but not stressful. Because you ought to be prepared.
This is the final step towards reaching Level 1 of Financial Freedom – freedom from fear. It is the ‘f*** you’ money we discussed back in the introduction, which gives you the freedom to walk away from a bad job, client or location if you’ve had a gutful.
To complete this step, you need to set up an emergency fund. This is an at-call, high interest bank account or money market fund with enough money in it to get you through an average-sized disaster or greater.
How much money is enough? Back in Step 2: Make a Frugal Budget, I told you to put away sufficient cash for three months’ living expenses before you start aggressively paying off debts. If you still have debts (aside from a mortgage), this is the amount to shoot for. If you are debt-free, it is time to level-up your emergency fund: it should be enough for six months’ to one year’s worth of living expenses.
[Edit: after 2020 I reckon 1-2 years’ worth is reasonable. It’s getting crazier out there.]
That’s quite a range. How much is right for you? It depends on your circumstances and comfort with risk. If your career is contract to short-term contract you might need more; if you have a more stable job or are pretty Zen then you might be content with less.
I personally have enough to live frugally for a year in an inexpensive country because I’m single and mobile. If you have a family then six months’ worth of living expenses would be the bare minimum I would dare suggest, and I would highly recommend closer to a year’s worth. Otherwise, how will you meet all your obligations, such as mortgage payments and monthly bills, if you lose your job and cannot quickly find another?
Where to Keep It
Your emergency fund should be in [book-exclusive content].
( . . . )
Because I live overseas, I keep an additional few thousand dollars in a local bank, in the local currency, in case my Aussie bankcard is not accepted for some reason. I also have a few hundred dollars in United States dollars (cash) handy while traveling in case I can’t get to an ATM for some reason. I’ve only needed to use this once, when none of the ATMs at Shanghai Airport would accept foreign bank cards and the hotel could not process my debit card. Sometimes everything goes wrong all at once.
It’s no good having money for emergencies if you can’t access it in an emergency.
[Edit: here’s more about pirate finance for my rambling readers]
By the way, I also keep a little cash in a side pocket of my day bag in case I ever forget my wallet. I also keep in there an umbrella, condoms, spare tissues, a hanky, headache medicine, band aids and a few other odds and ends whenever I go out. I’m that kind of person.
Do like the Boy Scouts with your finances: be prepared!
Aside from the financial advantage of never needing to borrow for emergencies and thereby fall back into debt, the emergency fund gives you peace of mind. Once you have saved it up, you will no longer have a near heart attack when your car struggles to start or when you get hit with a random tax bill you didn’t see coming. You’ll merely grumble, pay it, and get on with your merry life.
You’ll be much more relaxed at work when you know that, if need be, you could walk away. You’ll be more willing to say no to unreasonable demands, speak your mind if necessary, and filter work calls once you get home. If it came to it, you could even reject a rude customer or stand up to a bullying boss. Remember, you have f*** you money in your pocket. Any time you want, you can walk out the door.
Anecdotally, people who reach the ‘position of f*** you’ do not actually storm out the gates while playing the boss’ head like the bongo drums. More commonly they become bolder and more assertive; happy to work hard and do their jobs properly but unwilling to be treated like a doormat.[i] You’ve probably experienced this feeling already, when you’ve already handed in your two weeks’ notice and are starting to wrap up. You still get your tasks done but you feel much more relaxed and any workplace dramas are a source of comedic amusement. Having your emergency fund set up turns this tranquil period into a permanent reality.
There’s always that one employee who dares to speak up for what the others are thinking. Sometimes it is because they are naturally quarrelsome, but in other cases it is because their position is very secure. Soon, that will be your position.
Replenishing the Emergency Fund
Every time you cut into your emergency fund, you must top it up again straight away, even if it means putting other financial goals on hold. If you are still paying down debt, ease off and pay only the minimum until you get your emergency fund back to three months’ worth of living expenses, then get back to paying off those debts aggressively. Lacking an emergency fund puts you at risk of falling into further debt if a sudden expense comes up, so it must take precedence. Remember, avoiding new debt comes before paying off existing debt.
If you have no debts, pause your investing (Step 8) until you have your emergency fund filled back up. Remember, you should have chosen an amount that will keep you going for six months to a year. Once the emergency fund is topped up, you can get back into making those wonderful investments – but there’s to be no investing until you have your financial parachute ready to go.
Let’s look at the emergency fund in action with these charming examples:
Imagine that Tim has responsibly saved $9,000, which is enough for him and his young family to live on for three months. Now he is fully focused on paying off his debts, as per the next chapter.
One day Tim is hit by a truck while riding his bicycle and receives no compensation for required medical treatment because he was foolishly using an umbrella at the time. He has to cut into his emergency fund to pay $3,000 in out-of-pocket expenses.
Tim now needs to slow down his payment of debt to the minimum permissible in order to top up his emergency fund. Once it is back up to $9,000, he can return all his financial firepower to paying down those debts. And once those are paid off, he can start making long-term investments.
Compare the case of Tom. He has no debt and has already saved up a 12-month emergency fund of $36,000. He is currently putting his surplus income into long-term investments.
Tom is a very bad driver, and one day he drives right off the road and totals his car. Insurance does not cover the damage because he admits that he was eating a sandwich, drinking coffee, reading a book and plucking his nasal hair at the time.
He needs to buy a new car and the cheapest that will do costs $12,000. He cuts into his emergency savings account for this, not his long-term investments.
Tom then spends some months putting every cent of new savings into his emergency fund. Once it is back up to $36,000, he resumes putting money into investments.
One final note – inflation means that your emergency fund should gradually increase over time. Changed circumstances might also cause you to reconsider the amount required, i.e. if there are rumors going around of layoffs at your company or if you take on a mortgage. Review the amount about once a year and adjust as required.
What, my reader asks, is that it?
Setting up an emergency fund is super simple but too few people actually do it. Spend a few months getting it organized and you’ll be a financial red-belt. You will have already reached Level 1 of financial freedom – freedom from fear.
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