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Why a Fully-Funded Emergency Fund Matters

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Fully-Funded Emergency Fund Piggy Bank and Cash

Emergency situations can happen at any time. And if you’re not prepared, you might find yourself in a world of hurt.

Right now in the United States and around the world, the effects of the Coronavirus are wreaking havoc on the financial security of countries, businesses, families, and individuals.

Many have failed to adequately prepare for this situation. Not every effect is avoidable — like the number of people facing unemployment — but this situation highlights the importance of having a fully-funded emergency fund.

Financial security is one of the most important aspects of personal security during trying times. An emergency savings fund makes it more likely that you and your family can face the future without worrying about unexpected time out of work for an accident, an illness, or even a pandemic. Even a small emergency fund can make a big difference when the going gets tough.

Not everyone has the opportunity to create months and months of financial savings in case of emergencies. But if you do have the ability to save up several months of living expenses by spending less and saving more, you give yourself lots of peace of mind when bad situations arise.

With a harsh combination of rising unemployment and a slowing economy — the S&P 500 has dropped more than 37 percent in the month between February 20 and March 21 — it seems like the only thing rising is financial strain. Those who were living paycheck-to-paycheck going into this crisis with no backup cash are finding themselves in a worsening situation.

Let’s cover a few things:

  1. The importance of building up financial breathing room
  2. How much money you should have saved up in case of a disaster
  3. The best accounts for keeping your backup cash

Build Up Financial Breathing Room

Creating financial breathing room is our first goal when building an emergency fund. Too many people are living quite literally paycheck-to-paycheck. Many are overspending and adding to debt that consistently keeps money flowing out of their bank account. This makes it difficult or impossible to save up in the first place.

According to the consumers’ expenditures report by the Bureau of Labor Statistics, the average annual household income is around $70,000 before taxes, and the average annual expenses are around $61,000 after taxes. It’s clear that the average American is effectively spending 100% of their income.

While increasing your income is a worthwhile goal and something to work towards, if you find yourself overspending now as well as spending more every time you earn more, your best bet for saving up emergency cash is to reduce your expenses and destroy debt as soon as possible. Treat overspending and bad debt like the emergency that it is.

Having money reserved that can last you at least three to six months while you’re unable to earn more — likely for reasons completely out of your control — makes a huge difference in your quality of life during trying times.

Related: The Importance of Starting a Side Hustle and How to Succeed

How Much Cash Should Have in Your Emergency Account?

The common recommendation is to have at least three months of living expenses in your emergency fund. If that seems like a lot to you — and for most of us, it does seem like an awful lot — the best thing to do is to start by cutting all unnecessary spending.

What is unnecessary spending? It’s anything that you can do without and not get sick or die. Netflix? You can live without it. Eating out with friends? Fun, but unnecessary. You can eat and socialize for much less money.

This might feel like you’ll be having no fun, but remember that this isn’t forever. It’s just until you have your finances in order. I’m not trying to be cruel, and I know what it’s like. I’ve gone without these things when I didn’t have cash saved up. If I can do it, I promise that you can. And the benefits will far outweigh your temporary lack of expensive entertainment and nights out.

Once you’ve taken steps to reduce your spending and you have one month of living expenses covered, your savings account will start to grow faster and your momentum will motivate you to continue building up your backup stash.

When you have three months of living expenses saved up, you’ll be in a more comfortable situation than the vast majority of people when the times get tough.

Where Should You Keep Your Cash?

Some accounts are better for an emergency fund than others. As we’ve seen during the Coronavirus pandemic, stocks have not performed well. If you were relying fully on stocks to keep you going in a bad situation, you’d be down around 37 percent in your fund right now.

Ideally, you should place your emergency cash in accounts with very low volatility like a high-yield savings account.

High-yield savings accounts

A high-yield savings account offers interest on your deposits. While the interest percentage isn’t high compared to the average returns for the stock market, the benefits of a savings account is that your cash won’t drop when the stock prices crash. A savings account carries a much lower risk, which is what you want for your emergency fund. The combination of easy accessibility and low risk makes savings accounts the best place for your backup cash.

Remember, when the stock market is performing well, you might feel like your savings account is underperforming and you’re missing out on financial gains. But if all of your emergency dollars are in the stock market when it crashes, you stand to lose a large percentage of your cash reserves. Keep the majority of your backup fund in low-volatility, easily accessible funds like a high-interest savings account.

Look for accounts with low management fees. There are lots of online savings accounts that offer very low fees and a higher interest rate than many local bank branches can match.

Why a Fully-Funded Emergency Fund Matters

The best time to prepare for an emergency is before disaster strikes. The saying “make hay while the sun shines” has been stuck in my head watching unemployment rates rise and the US economy drop over the past month.

Living paycheck-to-paycheck when times are good leaves you unnecessarily susceptible to facing financial ruin when the entire workforce and economy are threatened. Just having a few months of living expenses saved up can make a huge difference in your ability to make it through a bad situation relatively unscathed. And having a fully-funded emergency account — around six months of expenses — can give peace of mind to know you can survive the vast majority of financial setbacks.

When building an emergency fund, the initial goal is just to have one month of your expenses saved up. You can accomplish this fastest when you reduce all unnecessary spending and stop increasing your debt through credit card purchases that you can’t immediately pay off. By the time you have one month of expenses saved up, you’ll have the discipline it takes to continue saving and, eventually, investing.

Remember to keep your emergency fund in low-fee, high-yield savings accounts. This offers the best combination of low risk, reasonable interest on your deposits (compared to interest rates on most savings accounts), and easy accessibility — all things you want in case of emergencies.

As we’re witnessing, emergency situations can and do happen with very little warning. By preparing for the worst, you give yourself and your loved ones peace of mind when the going gets tough.

If you’d like to save but don’t know how to start, the first step is to track your expenses with budgeting apps. I recommend Personal Capital and Tiller Money.

 

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Lyle

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