Milestone 4: Fully Funded Emergency Fund
Now that you’re beyond Milestone 3 and have your toxic debt paid off, it’s time to move on to Milestone 4, the fully funded emergency fund.
- Starting Point: Creating Your First Budget
- Milestone 1: The Uh-Oh Fund
- Milestone 2: Take Advantage of Your Employer Match
- Milestone 3: Pay Off Toxic Debt
- Milestone 4: Fully Funded Emergency Fund
- Milestone 5: Save 15%-25% of Your Income in Tax-Advantaged Retirement Accounts
- Milestone 6: Save for Flexibility in Bridge Accounts
- Milestone 7: Prefund Kids’ Expenses
- Milestone 8: Pay Off Remaining Debt
- Milestone 9: Total Financial Independence
In November 2015, I got laid off. The company I was working for found itself in a challenging place financially and I, among others, was given the opportunity to seek employment elsewhere.
This was a first for me and I wasn’t sure how you’re supposed to feel when something like this happens, but I was shocked that I wasn’t more concerned about money.
I knew I’d need to find gainful employment again, but my thoughts were drifting more toward a sense of rejection than poverty.
It’s not in my nature to be a worrier, but I’m pretty sure having an emergency fund that we could have stretched out to 6 months or more if needed did a lot for surprising any feeling of financial insecurity.
Looking back, having that peace of mind was priceless because it liberated my headspace a bit and allowed me to focus on finding my next job instead of harboring a sense of self-pity.
Having a cash reserve of several months’ worth of expenses is something we should all aim to have because uncertainty will pay everyone a visit sooner or later.
Unexpected illness, expensive home or auto repairs, economic turmoil, pandemics, disability, etc. There are an endless number of hazards that could force you into a position where you suddenly need a large reserve of cash to protect your financial goals.
How Much Should You Save?
Like many financial questions, the answer depends on the circumstances of your unique situation. There are a lot of variables that can push the needle in completely different directions.
This post is really going to serve as a guide more than provide you with a hard and fast number you need to reach.
In order to know how much money you need, you need to know how much you spend, which means you need to have a budget. You can take a look back at our post about budgeting here.
The widely accepted rule of thumb for a full emergency fund is 3-6 months of your normal expenses. This is actually a pretty broad range. I’d recommend tuning your actual emergency fund amount based on some of the following considerations.
You’re probably safe on the smaller (3-4 month) end of the range if:
- You have a very secure job like a teacher with tenure
- You’re in good health
- You don’t have much or any debt
- You have more than one income stream
- You share finances with someone else that’s working
- It would be easy for you to find another similar job if you lose the one you have
- Your car and home are in good operational condition
- You’re renting and can find a cheaper place to live quickly
- You don’t have anyone else depending on your income
- You have significant Roth contributions that you could access if you had to
Lean toward the 6-month end of the spectrum if:
- Your job isn’t secure
- Your health is poor
- You have significant debt
- You only have one source of income
- Your income fluctuates or is commission dependent
- It could take several months to find another job
- You’re driving a beater
- You have dependents
- You own a home
If you have a very unique or specialized job that may require relocation or an extended time to replace, you own a business, or you have a very high income you should probably save over 6 months of expenses.
Finally, for reasons we’ll discuss in Milestone 8, as you approach retirement, I’d suggest having around two years’ worth of cash available.
There are also a few ways to mitigate the unforeseen, allowing you to hold a smaller emergency fund.
1) Build Multiple Income Streams
Just like you can and should diversify your investment portfolio, having multiple sources of income can be an excellent safeguard for your finances.
There are many possibilities here, but I’d recommend starting by trying to find a way to monetize a skillset or interest you already have.
For example, a friend of mine started doing freelance photography in his spare time because he already had a lot of really nice equipment and a natural interest in the subject.
After several years of photography on the side, he runs a very profitable, full-blown business in addition to his nine to fiver during the week.
2) Build a unique skillset
Skills that are highly sought after but difficult to come by are great for securing the job you have while improving your prospects should you need to move on.
I work with a lot of very technically skilled people in my day-to-day business. Part of my job calls for me to evaluate the different risks we have as an organization.
I frequently find that one of our biggest risks is the amount of technical knowledge that exists only in the minds of several of our key engineers.
These people are subject matter experts in very specific fields and are invaluable to our company. We’d be in a serious bind without them and consequently, they are very valuable.
Be sure you take advantage of opportunities to hone, refine, or specialize your skillset when they present themselves.
This may require working out of your comfort zone for a bit or solving a challenging problem, but in the long run, it might make you a very tough person in your company to lose.
3) Know your disability/long-term care benefits
You may have benefits from your employer to back up your income in certain circumstances. These options are most often available due to a health-related income loss.
You are probably also covered by a government-sponsored unemployment insurance plan that both you and your employer have been contributing to during your working time.
Since you’ve been paying for it, you might as well apply for it during your unemployment. Just know that it’s probably not going to be very much money.
4) Reduce your debt
Another good way to reduce your emergency needs is to decrease the amount of debt you have to service during a low or no-income period. Obviously, it will be easier to get by if you have fewer bills to pay.
This is another reason we recommend paying off toxic debts in Milestone 3 of the Next Dollar Roadmap. It just gives you another level of flexibility when times get tough.
Where Should I Keep My Emergency Fund?
The question of where to place these funds is one I get a lot. Before I share some ideas, here are some key things to keep in mind about your emergency fund:
- Emergencies aren’t something you can time.
- You may need to be able to access emergency funds relatively quickly.
- You don’t want your emergency fund’s value to be exposed to possible fluctuations in asset prices.
- You don’t want to risk losing your emergency fund entirely.
Unfortunately, these requirements limit where we can responsibly store our emergency fund assets.
Real estate is not a good option because it can take a long time to liquidate and it’s subject to sudden changes in value which might mean you have to sell your investment at a loss.
Stocks, bonds, and mutual funds are also subject to sudden price fluctuations. While they don’t usually take as long as real estate to liquidate, it can still take several days for the sale of equities to settle so the money can be used.
Finally, don’t put it under your mattress. Your house could burn down, your dog may find it and eat it, you may forget about it, it might get stolen by the cleaning folks; there are lots of reasons this is less secure than a bank.
Ultimately, the investment options for your emergency funds aren’t really very exciting, but let’s take a look at some possibilities you may want to consider for pulling in a little interest without exposing yourself to unnecessary risks.
1) High-Yield Savings Account
I use the words “high-yield” loosely here. These accounts produce more interest than say typical savings accounts at your local bank, but it’s still nothing amazing.
You’ll likely find the best options for these accounts are with online banks. They can give a little extra in interest because they don’t have a lot of the overhead that brick-and-mortar banks are subject to.
One thing to watch out for on these accounts is introductory rates or rates that are designed to attract you to sign up, only to decrease later.
Some banks will even offer a cash incentive to sign up, but generally, you will be better off going with the option that has the longest history of paying out a solid interest rate.
Also, be sure to choose an account that is FDIC-insured. Most of these are. The FDIC insures your account in case your bank fails.
You’ll receive $250,000 of coverage for the account owner and an additional $250,000 per co-owner. So, if you co-own an account (usually with a spouse) you’d have a total of $500,000 in coverage.
2) Money Markets
There are two distinct “money market” types to address.
Money Market Accounts are usually available at your local brick-and-mortar bank and combine a slightly better interest rate with several restrictions on access to your money as compared to a traditional savings account.
Money Market Funds work like a mutual fund that holds a variety of cash equivalents like CDs and short-term notes and treasuries. Typically, Money Market Funds will produce higher yields than Money Market Accounts.
Money Market Funds & Accounts technically come with an inherent risk of loss, but it is relatively low. Even if you do lose some money on these you aren’t likely to see much of a dip.
Personally, the bulk of my emergency fund is in a money market fund within my personal investment account at Vanguard.
It also serves as the settlement fund for my taxable investment account. I can transfer the funds to my checking account quickly if needed.
3) Certificates of Deposit (CDs)
CDs are an agreement you make with a bank to keep the deposited funds for a specified period of time. If you remove the money before the CD matures, you’ll have to forfeit the interest you’ve earned or may even have to pay a fee.
CDs don’t exactly provide much flexibility, so many times people will build a CD ladder with a variety of maturity dates to mitigate the risk that they’ll need the money earlier than expected.
Personally, I do not prefer to use CDs because I find them to be too restrictive for the interest you can earn when compared to money market funds.
4) Checking Accounts
You probably don’t need a lot of explanation on how a checking account works but they are a practical way to hold money in a FDIC-insured account while also providing optimal access to your money.
The downsides are a higher risk of losing your money if someone manages to steal your debit card information and the paltry interest available in a checking account if you manage to earn any at all.
Another drawback is that you may be more tempted to spend your emergency fund if it’s in the same account as the money you use to cover normal expenses.
Checking accounts would not be my top choice for the reasons listed above, but mostly because there are clear options with better returns.
Wrap Up
A fully funded emergency fund is not the most exciting milestone on The Next Dollar Roadmap.
For one thing, it takes time and discipline to build up three to six months’ worth of expenses. Then once you have it, the purpose of the money means you can’t really invest it in anything that puts the principal at risk meaning your earning options are somewhat limited.
However, a fully funded emergency fund is absolutely necessary for building and protecting wealth.
Trying to maintain a significant net worth without an emergency fund to protect your assets from the unexpected is like riding a motorcycle without a helmet.
Be smart. Get your hands on some cash before moving on to the next milestone.
Our next post will cover Milestone 5 on our Next Dollar Roadmap: Maxing out your tax-advantaged accounts.
