Step 2 of My 5-Step Roadmap Towards Building a Solid Wealth Foundation
The 2nd most important part of any wealth foundation is ensuring you’re prepared when sh*t hits the fan. It’s impossible to build and grow your wealth without first figuring out how to build an Emergency Fund.
If you are reading this blog post, but haven’t yet read Step 1: How to Prioritize Your Debt, I suggest you read that post as well. These first two steps aren’t as sexy as investing, but they are crucial to laying down a solid wealth foundation. Step 1 and 2 can be worked on simultaneously, but you shouldn’t really move on to Step 3 until these two are completed.
Let’s Talk About Why You Need an Emergency Fund
A flat tire. An unexpected pet bill. A year-long pandemic. A spontaneous visit to Target. You
know the type. You’ve heard this concept before and you have these emergencies every so often, but you never seem to get around to building an Emergency Fund.
Let’s play this out with a real world example that many of us experience. God forbid your cat gets sick, forcing you to rack up a $1,000 vet bill. I know for a fact this is an inevitable expensive experience every pet owner goes through at some point in their lives.
If you don’t have that cash on hand in your checking or savings account, what do you do? Most likely, you’re going to charge it to a high-interest credit card. And…the debt spiral has been activated.
Another ill-advised option to take if you don’t have enough cash on hand is to pull it out of your investments. If those investments involve penalties and taxes for taking it out early, then it’s probably just as bad as an option as going into high-interest credit card debt.
If it’s a bigger emergency, say a big company layoff, and you lose your job for six months, you may have to resort to credit card debt and disrupting your investments. Either way you slice it, these bad money moves would crumble your wealth foundation and potentially set you back for years, not to mention prevent you from moving on to the important investing steps to come.
How to Calculate How Much You Need in Emergency Funds
You need anywhere from 3-6 months in essential living expenses saved up. Include your rent/mortgage, all debt payments, utilities and food. Don’t include extras like travel for fun
and mani/pedis.
It’s important to note that the suggestion to have 3-6 months in essential living expenses saved up is a rule of thumb. There is a misconception that an Emergency Fund is something you need for specific events, i.e. losing your job for 6 months or your insurance deductible. Instead, it should be treated like an umbrella for any and all potential emergencies because the likelihood of more than one devastating event happening simultaneously is pretty low.
In reality, most times there is enough time between “emergency” events to build back up the Emergency Fund. With that being said, if you have a very low risk tolerance, you can use your own judgement and increase your Emergency Fund/cash goal if that makes you feel comfortable. Just remember that there’s a risk with keeping too much cash on hand, too.
Here are my suggestions determining exactly how much you need within the 3-6 month range:
- If you are single with no dependents and your expenses are fixed, 3 months (the minimum) is enough.
- If you are married or have a partner that depends on (i.e. you combine your incomes to pay household expenses) your income, but you do not have any dependents, you want to strive for 4-5 months.
- If you are married or have a partner that depends on your income and you have at least one dependent or child, you want to strive for 6 months.
Think of it as a spectrum, and the more people in the family unit that need to be accounted for, the closer your Emergency Savings should be to the 6-month goal.
This step can be done alongside step 1 and potentially step 3, but you really shouldn’t move onto step 3 (investing) until you have at least $3,000-$5,000 in essential living expenses saved up in cash at the bank. And if you decide to start investing before you reach your Emergency Savings goal, do so while you’ve also got an automated monthly contribution to your Emergency Savings. You will have to use your best judgement on how to divvy up your savings each month.
Caveat: The only time you should be working simultaneously on steps 1, 2 and 3 is if you have a 401(k) that offers a company match. In that case, you should contribute only up to the match to take advantage of that free money, and have automatic contributions going towards both your Emergency Funds and high-interest debt.
How to Build an Emergency Fund
The best way to build your Emergency Fund is to set up a monthly automated amount from your paycheck or main checking account to your Savings account, so it can be out of sight, out of mind and running like clockwork in the background of your life.
Take a hard look at your budget to see what you can afford to put into a savings account each paycheck (even if you can only start with $50-$100/month). Decide on an amount–you can always increase or decrease in the future–then set up the automatic contribution.
If you are living paycheck to paycheck without any extra savings each month, it’s time for you to do a living expense audit, especially of your recurring expenses (hello, sneaky streaming services!) If this gives you anxiety, and you don’t know where to start, I’ve got a worksheet coming your way soon!
When you are ready to get serious about growing your wealth, you’ll be excited to confront your spending, no matter what income level you are at. Everyone has room to improve through methods of reducing, budgeting, negotiating and eliminating.
Savings Accounts vs. High Yield Savings Accounts
Before I get into the pros and cons if a high yield savings account, it’s important to know that a HYSA is NOT a substitute for investing. It’s simply an alternative to a regular Savings account, and is meant to hold cash you need on hand for Emergency Funds and short-term goals (within the next 2-3 years.) They are “high-yield” only compared to traditional banks.
Now, as you are probably aware, inflation ranged from 8-9% in 2022, which begs the question, “if the value of your cash is decreasing due to high inflation, is it really “safe”?” Inflation is the main reason you want just the right amount in cash, and put the rest to work through investing.
In order to attempt to decrease or stall inflation, the Federal Reserve has been increasing interest rates, with the hope of curbing consumer spending. Rising interest rates isn’t what you want if you’re in the market for a new mortgage, car loan or any other big purchase requiring you to go into debt, however, it does provide opportunities for your cash.
This is where a High Yield Savings Account (HYSA) comes into play. Before 2022, I was lukewarm on HYSA because they weren’t earning enough to be worth the hassle, but that has changed in this high-interest, high-inflation environment we’re all in right now.
Where your traditional savings account may be getting less than 1%, a HYSA may be earning you upwards of 3.75%. It doesn’t come without it’s drawbacks, though.
Some HYSA Cons to Consider:
Withdrawal limits – check to make sure you’re able to get money out when you need to, without drawing a penalty. This speaks back to my recommendation of only using a HYSA as an Emergency Fund, not a checking account replacement.
Lack of ATM access – Most HYSAs are online-only, so again, don’t use one as a checking account which would require easy access all the time.
Variable Interest Rates – aka APYs will fluctuate with HYSAs, so that means the APY at sign-up may change throughout the months and years. This is something to keep in mind if interest rates come back down, and you’re not enjoying the drawbacks that I’ve mentioned here.
Transfer Wait Time – it may take 2-3 days to hit the outside bank you want the funds to go to.
At this moment, I still like the idea of using a HYSA because they have some great features and can help mitigate some of the effects of inflation on your money, but it’s important to keep these downsides in mind when you’re considering where to stash your cash. I would just make sure you leave enough in your regular checking account to pay your regular monthly bills at all times.
Here are a few HYSAs that NerdWallet suggest for 2023.
Exceptions to the rules of Emergency Funds to Consider:
- Emergency Funds is just one of two parts of your Short Term Bucket (cash you need on hand.) If you have a big goal you’re saving for within the next 2-3 years, then you need to keep that money in cash, too. Examples include a down payment on a new home, IVF treatments, a big vacation, private school fees, etc. However, if the goal/funds are 3+ years away, you should put them to work in a conservative or balanced investment strategy.
- If you are a business owner, you need a separate/additional Emergency Fund for the business. Use the same method to calculate and do an expense report.
So, on one end, you may have a single woman with no dependents, a stable income, low expenses and no big goals on the horizon who only needs $9,000 in cash. On the other end of the spectrum, you may have a young family where one of the spouses owns a business, they have 2 young children, high expenses and they’re saving for a down payment on a newer, bigger home who will need to keep upwards of $100,000 in cash.
It all depends on your unique situation, but one thing remains the same: something is better than nothing, and there are plenty of tools at your disposal to increase your Emergency Fund.
I hope you leave this post knowing your exact plan on how to build your Emergency Fund and that you feel more hopeful than ever to NOT be one of those Americans that only has $1,000 in Emergency Funds or worse living paycheck to paycheck…you can do better!
Join my FREE Wealth Roadmap Class on March 1st, 2023 as I guide you through all the steps so you can start (or re-start) your wealth journey with clear action steps.
This blog post was written on 2/2/23 by Danielle G. Nava, CFP®
The opinions voiced in this material are for general information only and are not intended to provide specific advice or recommendations for any individual. All investing involves risk including loss of principal. No strategy assures success or protects against loss.