Finding Financial Freedom with an Emergency Fund

Finding Financial Freedom with an Emergency Fund

I was recently asked how old I was when I was no longer living in poverty.  I answered that there are two answers to that question.  The point at which I was no longer living in poverty, technically, was when I landed an $11/hour job at the age of 20 (15 years ago for those counting along at home).  However, it was only relatively recently, after my graduation from business school, when I started to feel that I would never live in poverty again.  This came when I had pulled together an emergency fund.  I cannot adequately explain to you the feeling of freedom this provided to me.  As you can read in my bio below, the goal of creating this site was to share this feeling of freedom with all women.

As such, today’s topic de jour is the safety net fund.  This is the fund that you put in place in the event of emergencies, and, unfortunately, emergencies do happen.  Like it or not, you cannot control whether or not you will wake up tomorrow and suddenly not have access to a source of income for one reason or another.   However, you can control how prepared you are for that moment.  That’s the only thing you can control, so let’s get to it.

How Much Do Emergencies Cost?

First things first, how much do you need to save?  Common advice bases this figure on your “monthly expenses”.  As I have mentioned before in “How I Created My Investment Priority List” you do not necessarily base your safety net on your current monthly expenses.  I guarantee that your spending habits will change dramatically if you lose a job or become injured or sick.

Stay tuned later this week when we discuss budgeting, but for now you would just need to understand that I have a regular budget and an emergency budget.  In the emergency budget I estimate the smallest amount of money I will need to meet my monthly expenses.  This includes my “needs” of home, food, car, health insurance, etc.  Do make sure to consider those expenses that occur once per year.  In my case this includes my homeowner’s insurance.  You would delete any items from your budget that are “wants”.  This includes eating out and entertainment.  You can entertain yourself plenty in the future when you celebrate a new job or better health.

Here is where I point out how, by keeping your monthly expenses low, you will have both an easier time surviving in an emergency but also have an easier time using your current income to save for an emergency fund.  The same thing works for retirement savings.  If you can keep your monthly budget low, then your retirement savings will last you longer and you will have more extra money every month to save for the future.

When Will the Misery End?

Now that you have determined the monthly emergency budget amount, you need to figure out how long you may be without an income in an emergency.  Expert advice varies on this topic.  Most say three to six months.  The most conservative opinion comes from Suze Orman who advises us to save for 9 months of living expenses.  This advice was based off of data she received from the Great Recession.  The most recent data (December 2014) shows that the average duration of unemployment in the United States is 32.8 weeks (8.25 months if you assume a four week month).  That’s a miserably long haul if you are not prepared for it.  It’s, quite frankly, a poverty maker.  With that in mind, Suze Orman’s advice is what I follow.

Ultimately, it is for each of us to decide our comfort level where the emergency fund is concerned.  Nine months of savings provides me with a sense of comfort.  That could be different for you.

Saving Your Way Towards Financial Freedom

Now that you have your monthly emergency budget, and the number of months you wish to save for, you multiply those two sums and arrive at the amount of money you will need to support yourself if your income falls through.  Now take that amount and multiply it by 1.3.  I will tell you below why this should actually be your safety net savings goal.

You might feel intimated by this amount at first.  I certainly did.  It took me a long while to save for my safety net fund.  I mean, you are literally using your monthly income to save many months of emergency expenses.  Just take it one step at a time.  First save for one week of emergency budget, then two, then three.  Soon you will have your first month of emergency expenses saved up.   Then move on to saving the second month.  Leave room to congratulate yourself and do a little happy dance at each iteration.

Use the following tips to help you along:

  • Set up your monthly budget. Many people end up saving money only to spend it paying for bills and other expenses. I was guilty of this when the air conditioner went bust years ago.  You need to start with a solid monthly budget. We will cover this topic later in the week.
  • Find bills that you can reduce or cut.  For example, I just recently cut $50 off of my cell phone bill, which frees up $50 I can now save instead of spend.
  • Set up a monthly savings goal. My savings goal was $24,000.  I set up a monthly savings goal over an extended period of time, it could take three to five years, in order to save that amount.
  • Force savings, sometimes called “paying yourself first” is the best way to set up a savings habit.  Set this amount up as an electronic debit from your checking account into a savings account.
  • If you receive any “free money” (examples include an income tax returns or job rewards/bonuses) then tag that money to go directly into the emergency fund.  Doing so will put your savings on the fast track.  Also, if you are getting income tax returns, find out why they are not as awesome as you think they are.  Get what you deserve from each paycheck and put that extra money towards your emergency fund instead.

Let Your Emergency Fund Make You Money

Now there is the question of where to put your money.  The going advice here is to put your emergency fund in a “liquid” account that you can access on a few day’s notice.  Most people select a standard savings account for this.  However, I recently received better advice.  Remember when I told you to multiply your would-be emergency fund by 1.3?  Here is why.

I recently read on Betterment that the wisest way to manage your emergency fund is by investing the money in a diversified portfolio.   This is because if you intend to hold on to this safety net fund for a long time, one hopes you never have to use it, then investing it is a better choice since cash in a savings account will “lose value” since it will not grow with inflation.  In other words, things will get more expensive, but your emergency fund will remain the same.

Here is how you would invest your safety net fund:

  • Keep your money in a savings account until your safety fund is fully funded
  • Save 30% more than you need in order to create a safety net for your safety net.  The biggest market plunge on record, which took place during the Great Recession between July 2008 and March 2009, was 23%.  Therefore, if the markets plunge again you will still have the money you need to meet your expenses in an emergency.
  • Diversify your investments in a portfolio with moderate risk.  This means 30-50% of that money is invested in stocks while the rest is invested in less risky investment vehicles such as bonds.  I keep things simple and use a mutual fund with moderate risk.
  • As interest is earned on your emergency fund investment fund, transfer excess funds to another account set for another goal…perhaps a Roth IRA or a vacation fund.

I originally received this safety net post prompt as a request from a reader.  Do you have any savings and investment questions?  I’d love to hear them.

Melody grew up in poverty, and she was homeless throughout most of her childhood. Even after the hard work of getting out of poverty was accomplished, she still lived in fear of the next bad thing that could happen. She knew that, without the security of a safety net, one misstep would mean certain disaster. It was not until this safety net was established that she truly felt liberated and free from the anxiety of living in poverty once again. She is now motivated to share this sense of freedom with all women.

1 Comment

  1. Lannie Kali 4 years ago

    Melody, This was so good and encouraging! I ran some numbers and jut doing that act of adding it up and writing it down was empowering! Thank you for sharing a little bit of what works for you with me!

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