Monday, October 21, 2013

Lesson from the Government Shutdown - Emergency Fund

I cannot say this enough: EVERYONE must have an emergency fund!  It is, short of food, shelter and clothing, the most important financial goal you should have.  I would put it up there with budgeting as the greatest unlearned financial lesson of our time.  Three to six months of expenses, in a reasonably accesible place (bank account).  The choice between 3 and 6 months depends on the reliability of your job.  Despite recent history, a government job or being in the military usually means 3 months.  Unstable or new job means 6 months.

The good news is that it's not 3 to 6 months of income, it's 3 to 6 months of expenses.  Add up all your monthly bills that you have to pay (you can cancel cable but not electricity), add in reasonable amounts for food, gas and other expenses (leave out eating out), and you have a good monthly amount.  Multiply by the number of months and you have your goal.  If you have slack in your budget such that you can get there in 6 months or less, just do it and ignore the rest of this article.  If your budget is tight, keep reading.

I give this advice to at least a hundred people a year, and at least 98 tell me there is simply no money in their budget to make it happen.  This is, to say it politely, bulls**t.  The tighter your budget, the more important an emergency fund is, because you can't afford an emergency!  And one WILL happen.  Here's a good hierarchy for how to make an emergency fund work without a good, flexible budget.

1.  If you have no emergency fund, stop your 401K contributions, cancel your cable, cancel your Netflix, sell expensive, unecessary crap you have around the house, eat beans and rice every day, buy NOTHING that is not essential to survival, NEVER eat or drink anything you didn't make at home, and save all that money until you have one month of expenses.

2.  Once you have one month, you can eat an inexpensive variety of food, at home, but not out on town.  You can also buy small amounts of non-essentials (like an occasional coffee at Starbucks).  Once you have 3 months expenses, you can slowly reintroduce expenses into your life.  Now comes the hard part:

3.  Write a budget.  Really - you HAVE to have one.  Rich people have budgets, it's how they stay rich.  You need one more.  You just figured out the minimum you need to live in basic comfort (what you spent a month to get 3 months saved up.)  Start there and compare it to your income.  Add back retirement savings, cable, Netflix, some extravagances like eating out, and other items based on your priority.  Add an amount for continuous emergency fund funding.  Ideally this should be at least 5% of your total desired emergency fund.  This way, when an emergency happens, you have a way to rebuild it.  Use this money to get to your goal if it is more than 3 months.

4.  If you're lucky enough not to have an emergency for a while, use the excess above your target to occasionally buy yourself something cool (like some of the stuff you sold to get an emergency fund).  This is your reward for good financial planning.

Emergencies happen - be prepared!

This is my favorite book on personal finance:

1 comment:

  1. You are so correct. Planning for the worse case situation is important to surviving these days. Understanding how far your savings will take you is so true. I learned this lesson years ago the hard way. Good Post! Thanks for stopping by me site!

    Mr. MakingUsmile


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