One of the most common issues people trying to create a financial plan struggle with is the concept of an emergency fund. There are a host of roadblocks individuals face with identifying the best way to deal with unexpected changes in their professional lives and with their health. Adding to the problem is the fact that we never know when a huge event is going to happen and how it will affect us. How much we should put back, how to consistently save, and where our “rainy day” fund should go are all very common questions that have several answers depending on your comfort level and situation. Today I will dive into this complicated area of personal finance and share some advice on how to approach adding this layer to your financial picture.
How Much Should I Have In My Emergency Fund?
Setting a savings goal can be as easy as plucking a number out of the air, but how do you know that it makes the most sense? There are lots of “rules of thumb” in terms of savings goals. One of the most common is the “6 months of expenses” rule. This is simply your monthly expenses times 6 months. So a couple who spend a total of $4,000 a month on housing, childcare, food, and other discretionary expenses should have around $24,000 back in their emergency savings. However, this could be misleading, as households often have income coming in in different fashions. So, let’s look at two fictional households to see why this may be an issue. Annie and Blake are our first couple. Annie is a few years out of college working as a teacher, while Blake just finished his degree and is working an entry-level marketing job. Both earn $50,000 a year. In this first case, if something tragic were to happen (i.e. Blake’s firm downsizes and he is laid off), Annie’s income can supplement the family while Blake finds new work. They are cushioned from losing all of their income, and may only have to dip a little into their emergency fund for support until Blake is working again. Now, let’s look at our second couple. Charlie is in the middle of a career change, working a part-time job for about $15,000 a year while he attends college full-time pursuing a degree. His wife, Dana, has a strong job as a lawyer at a private practice in their town, and her $85,000 annual income supports the family while Charlie pursues his degree. Now, if Charlie decides that the part-time job is too stressful on his school schedule, it doesn’t harm their combined income nearly as much. On the other side, if Dana’s law firm downsizes and decides to move on, the family income is crippled. So what’s the point? How your household income is structured MATTERS in an emergency fund plan. For dual income households with individuals who earn close to similar salaries, the emergency fund doesn’t have to be a large amount. It’s quite feasible for our Annie and Blake to be able to have 3-4 months of their incomes in the emergency fund, or around $25,000. However, Dana losing her job would cripple the financial situation for her and Charlie. It’s probably better for these two to have 6-8 months in an emergency fund, putting their fund around $50,000-$60,000. When Charlie finishes school and the incomes start to become a little closer, they can put that excess amount in the emergency fund to work in their retirement plans. For a single individual, the same theory applies to them as it would to Charlie and Dana.
How Do I Start Saving?
Identifying a goal is great, but the hard work is actually figuring out a way to hold yourself accountable to creating and maintaining a saving plan. One huge reason individuals who contribute to a 401k plan are more successful at saving is because the money is put into the plan before they ever receive their paycheck, so the money is never actually in their physical possession. “Out of Sight, Out of Mind.” It’s very hard for many people to save toward an emergency fund, simply because we see the income and start to tailor our lifestyles to meet that income level. The trick is to “Pay Yourself First.” Identify your income, and before anything else happens with your budget, pull out an amount of your pay that will be earmarked for the emergency fund. This could be as simple as “I will pull out 5% of my paycheck each week and put it in the emergency fund.” It goes into the fund (and hopefully the self-discipline is there not to pull money out of there to meet a budget shortfall), and we forget about it! One great trick to this is to come up with a list of “actual emergencies” with your partner that are agreed emergency expenses. Things such as immediate home repairs like a broken A/C, or a deductible for a car accident. Lastly, a good trick to help keep your hands off of the emergency fund is to keep a small amount of your emergency fund immediately available once you’ve proven to yourself you have the self-discipline to not dip into it. Keeping a few thousand dollars in the checking account will give you peace of mind that you can react immediately to an emergency situation.
Where Should I Keep It?
We get this question quite often from clients as well. There are pros and cons to all the different emergency fund storage areas. In the currently low-rate climate we find ourselves in, it doesn’t do much good to try to chase the highest interest rate, as all will be comparatively low. That being said, here are a few options.
Traditional Savings Account – At your bank in a savings is a clear and easy option. The biggest pros to this account are the ease of access (it’s right with your other accounts) and you have fewer institutions to deal with. With a traditional savings account, the biggest drawback will be the lack of interest you are given, even when we eventually start to move to higher rates down the road.
Money Market Fund – One tool banks use to try to earn your business is to offer you bonuses and higher rates to use a money market fund. These can be useful, as they typically yield higher interest rates than a normal savings account. However, most of these promotional rates have a set time before defaulting to the normal, lower rate. This may find you “bank-hopping” to find the lowest rate, which can be a pain. Additionally, even money market accounts are not yielding much interest, further making this strategy infeasible.
High-Yield Savings Accounts – These accounts are typically found with primarily online banking institutions, and can offer interest rates that are comparable with money market funds. The key drawbacks for many clients is the lack of a physical branch or people to go see, and for some the distrust of putting their money into an online system. Even these savings accounts are suffering from low interest rates.
For individuals and families trying to construct a financial plan, establishment and maintenance of an emergency fund ranks with life insurance and debt load as the three biggest items to gain control of before starting a long-term investment plan. At Resolute Wealth Management, we work with clients everyday to help structure their financial picture and coach them to reach their goals. If you have more questions about emergency funds, wish to leave some feedback, or want to set up a meeting to talk about how we may help in more detail, please reach out to me via email or give me a call. Have a wonderful week!
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Mitch works at Resolute Wealth Management as a Financial Consultant. Mitch's primary role is to assist in delivering a professional level of service and support to our clients in all aspects of the planning and investment process. Mitch specializes in working with clients to identify life goals and aspirations and in creating investment strategies that assist them in meeting their goals.
Mitch began his career assisting customers through his managerial roles in the retail sector with GameStop and later with Ohio CAT, a dealer network for Caterpillar machinery. During that time, Mitch became passionate about providing a high level of customer service and discovered a passion for working with people. Mitch loves working in personal finance and investment strategy and ultimately decided to change career paths to pursue an opportunity to use these skills to assist families to meet their goals and aspirations. Mitch has 3 years of investment experience with local firms in the Dayton area, where his primary responsibilities were focused on supporting the operations of the firms as they worked with their clients.
Mitch graduated in 2018 from Wright State University with a Bachelor of Science degree in Finance with a focus on investments, and recently completed his MBA at The Ohio State University Fisher College of Business in December of 2020. Mitch is currently a CFA Level 3 Candidate, and recently sat for the examination in May 2021. Mitch currently lives in Fairborn, Ohio with his wife Lisa.