Having an emergency fund is a key component in attaining victory over your finances. As such, it's important to start one right away.
There are many benefits to be gained by having an emergency fund, and no drawbacks. It may feel like a drawback while you're putting in the extra effort to build the fund, but will provide great reward once you have it.
After you've put together a budget, start working to build your SES. This is your initial emergency fund to put in place until after you've paid off your debt, and will keep you from taking on more debt.
STEP 1 - Do a bit of research to find the best savings vehicle for your emergency fund. Do not use CDs (certificates of deposit) or other investments that will tie up your funds. It must be liquid, easily accessible, and penalty-free. This is important. If you put your SES in a higher-yielding vehicle in the hopes of growing it faster, you defeat the purpose of your emergency savings. You'll find yourself protecting your investment, rather than the savings protecting you. Yield is of no concern here. Also, keep it separate from your "operating account" so that you're not tempted to use it for non-emergencies.
STEP 2 - Put any extra cash into your SES as soon as, and as often as, you can. Squeeze money from your budget, sell something, mow the neighbor's lawn, whatever it takes to get your SES up and running quickly. NOTE: If you already have a chunk of money in an investment, take it out (even if you take a penalty hit) and use this money as your SES. It must be liquid. Using what you already have will put you ahead of the game, greatly benefiting you in the long run, so take advantage of what's already there.
STEP 3 - Once you hit $1000, celebrate! You have your SES in place to catch any surprises while you focus on eliminating your debt. Why $1000? I have noticed that whenever an appliance breaks down or the clutch gives out, it always seems to cost several hundred dollars to fix. A thousand is a nice round number that is enough to handle those pesky surprises.
STEP 4 - Focus your energies on eliminating debt. It's much easier to pay off your debt and ditch the credit cards when you know you have a safety net in place.
STEP 5 - If an
emergency comes up, pay for it and go back to paying the minimum on your
debts until you're able to replenish your SES. Then resume your debt elimination.
STEP 6 - Build an FEF (Full Emergency Fund). Once your debt is eliminated, continue using the snowball effect from debt repayment, but instead, you'll focus those payments on building up a full emergency fund. This FEF is the "new and improved", "bigger and better" version of your emergency savings.
That will depend on your family's basic monthly expense needs. Go back to the budget you set up and find out
how much you generally spend per month.
Keep in mind that you usually spend more than you need, so basic needs
will often be less than what we budget.
When times get tough, we could and should cut back on expenses until
we're back on solid ground. Your FEF
should provide 3-6 months' worth of expenses
for any big emergency that could potentially kick your feet out from under you
(a job loss, medical bills, anything that could knock you for a loop for
NOTE: the FEF
is not for purchases or vacations. Also, Christmas is not an emergency. These are expenses that should be planned for
in your budget.
What if the emergency you end up facing isn't about not having enough money? What if your daily challenge stemmed from a natural catastrophe: you can maybe access your money at the bank, but you can't get your hands on any food at any store? Emergency preparedness should be part of your emergency plan, and stocking a month's worth of food in your pantry can be considered part of your emergency fund. Keep it stocked up at all times, and you can reduce your FEF by an equal amount.
This is a scenario we tend to dismiss. Don't underestimate
the value of food in your emergency "fund".
The SES and the FEF give you
freedom from using credit cards for emergencies, and enable you to plan ahead,
instead of sinking into
the debt cycle or being led around by the nose by each successive crisis. Whenever the need arises to use your emergency savings,
always replenish it quickly and move on.
"Therefore everyone who hears these words of mine and puts them into practice is like a wise man who built his house on the rock. The rain came down, the streams rose, and the winds blew and beat against that house; yet it did not fall, because it had its foundation on the rock. But everyone who hears these words of mine and does not put them into practice is like a foolish man who built his house on sand. The rain came down, the streams rose, and the winds blew and beat against that house, and it fell with a great crash." Matthew 7:24-27
Once your debt is paid off and you have built up an investment portfolio, consider whether or not some of your emergency fund might include any income-producing investments you have that you don't currently use as income. I'm not talking about the investments themselves, but the income from those investments. For instance, if your income portfolio spins off, say $250 per month in dividends, then you could reduce your Emergency Savings account balance by $1500 ($250 X 6 months). That $1500 could be invested back into your income portfolio to spin off even more in monthly dividends, putting it to more effective use while keeping your 6-months' expense figure intact.
However, don't carry this idea too far in an effort to "put all that money to better use". The point of the emergency fund isn't just to cover 3-6 months' expenses, but also to provide a large liquid chunk of money on short notice. I do believe your investments can eventually help cover you during a dry spell, but liquidity and protection of principal are key components of your FEF, and not to be taken lightly.
As a rule of thumb, and depending on the solidity of your income investments, always keep at least the equivalent of 3 months' expenses safe and liquid. The other half could potentially come from any non-retirement income from investments that you don't already consider part of your current income.
Weigh this one carefully to fit your own needs and
always keeping in mind the real purpose of the emergency fund.
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