Our very own Marcus Holzberg, CFP® was recently featured in an article from Bloomberg Wealth about emergency funds.
Financial emergencies happen. They could be a job loss or partial loss of income, a sudden illness or accident, or unforeseen home or car repairs. Regardless of their size, it can often feel like these events derail your financial stability and occur at the worst possible time.
A dedicated emergency fund is a foundational element of your overall financial well-being and acts as a way to protect yourself when inevitable unplanned expenses occur. Having money set aside puts you in a better position to get back on your feet quicker to reach your long-term financial goals. It can also take some of the sting out of the financial burden to meet those expenses because you know you took the time to plan for the unexpected.
What Is an Emergency Fund?
Due to the unpredictability of emergency events, having cash reserves on hand is a good idea to cover or offset expenses from unforeseen circumstances. These funds should not be used to meet everyday routine expenses but act as a safety net only to be tapped for emergencies.
Why Do You Need an Emergency Fund?
According to Bankrate, 57% of U.S. adults are uncomfortable with the amount of emergency savings they have, and 22% have no emergency savings at all. Therefore, if these individuals were to inevitably have a financial shock, even a minor one, this could set them back. They may have to turn to debt, which could leave a lasting impact. They may have to withdraw from retirement funds before they turn 59 and a half, potentially incurring additional income taxes and penalties.
Emergency funds create a buffer to help you through difficult and unexpected challenges. They help keep you afloat without having to rely on strategies that may leave lasting damage to your financial future. Also, having a healthy, risk-free emergency fund is part of the foundation with which you build out the rest of your overall financial plan and helps counterbalance the risk of your total portfolio. By using a portion of your money for riskier investments (like stocks, bonds, real estate, etc.), it is critical to offset that risk level by being overly cautious with other funds.
What About Borrowing to Cover an Emergency?
If possible, you should explore other options to meet an emergency expense before you borrow. Taking on debt has potential long-term ramifications on your financial plan. Of course, not everyone has the means for emergency expenses, so they may have no other option but to borrow. Before you do so, it is worth understanding the risks and why you may want to rely on something other than borrowing to cover emergency expenses:
If you lose your job, you may not have enough saved to meet everyday expenses while you search for another position. In this situation, debt can quickly snowball, leading to even more financial hardship.
If you already have multiple other debts, relying on more debt furthers your liabilities and makes becoming debt free that much more challenging.
During economic downturns or uncertainties, lenders may issue fewer new lines of credit and reject more applicants to reduce their risk levels. Consequently, it may be difficult to secure a loan, and you may not even be able to borrow at all.
Can Insurance Help Protect You in an Emergency?
Absolutely. In addition to your emergency savings fund, transferring or sharing some of the risks of unpredictable situations is a crucial component of your overall financial plan. Some of those insurance plans include:
Disability insurance, whether short or long-term, can help you in the event you have a disability inhibiting your ability to perform your job or activities of daily living.
Ensuring you have adequate health insurance is a staple of being able to cover medical emergencies. Also, if your health plan is compatible, setting up a Health Savings Account is a great way to prepare for unexpected medical expenses.
Sufficient homeowner and car insurance coverage is also critical to protecting your property from storms and accidents.
However, most often, insurance is not enough. Policies are written to usually only cover a portion of covered expenses, albeit a significant portion. It's a good idea to be extra cautious and have funds earmarked for emergencies that supplement your policies.
How Much Do You Need in Your Emergency Fund?
The amount of emergency savings you should have is usually discussed as a ratio of cash reserves to monthly non-discretionary expenses. In other words, it answers the question: how many months could you pay your bills using only the cash you have on hand?
The benchmark for this ratio is typically three-to-six months' worth of expenses in a liquid account. However, this benchmark highly depends on your lifestyle, obligations, family needs, job stability, and the current job market. Some common scenarios to consider may be:
How long could you be out of work if you lost your job? If you have a highly specialized job, losing it could mean replacing it takes longer than six months. You may also work seasonally or on a project basis, which could mean longer stretches without sustainable income.
What does your job security look like? A tenured faculty member of a school may have a lower risk of unemployment and would not need as much money in their emergency fund. In contrast, someone working in a cyclical industry where layoffs happen regularly may want a larger emergency fund.
Are you prone to injury or illness? If you are an active person who is more likely to injure yourself, having a larger emergency fund might make more sense in case of surprise medical bills from injuries. Additionally, if you travel internationally, your medical insurance may or may not cover medical expenses while you are abroad.
What is your risk tolerance? If you want to be more aggressive, you can lean towards three months of expenses in an emergency fund; if you want to be more cautious, six months is more prudent.
The considerations are not limited to the list above; therefore, your emergency fund ratio should be revised according to your situation and the current economic climate.
How Do You Build an Emergency Fund? Or How Can You Save More for an Emergency Fund?
There are several strategies you can use to go about systematically building your emergency fund. Different methods may work better for some folks, given their financial circumstances, but may be ineffective for others. You should find what works best for you, whether you employ just one strategy or multiple, and stick to it. Remember that it will likely take time, so stay the course and keep track of your progress.
Look At What You Spend and Manage Your Cash Flow
This strategy is effective for everyone, particularly those who live paycheck-to-paycheck or are just starting in the workforce. Understanding your cash flow and creating a budget you can reference helps you see how much you are spending and where there is room to save.
A great DIY place to start is with a spreadsheet. Track your monthly income source(s) in one column – these are your inflows. In another column, track your expenses and debt repayments – these are your outflows. Then subtract your outflows from your inflows. This shows how much discretionary income you have left over, of which you can save all or part.
Be sure to update and review this spreadsheet throughout the year. Also, many banks, credit card companies, and savings apps offer great budgeting and inflow/outflow mapping tools at no additional cost to you.
Set a Savings Goal and Create a Savings Habit
Once you have a goal of how much you want in your emergency fund, you can plan how much you would like to save in a given period. Having a specific goal in mind helps you plan and stay motivated.
Moreover, creating a system whereby you make consistent contributions is a good idea. Use the 'pay yourself first' philosophy. When your paycheck hits your bank account, make a savings payment to yourself first before your expenses. In this way, you can think of building your emergency savings as a bill, and you should pay that bill first before your other bills. Also, setting up an automatic recurring transfer to another account earmarked as your emergency fund helps you stay disciplined.
Again, make sure you regularly monitor your progress. Be patient, and do not get discouraged. It may take some time to hit your goals but keep at it.
Something is Better Than Nothing
Remember that every penny counts. Start with small, attainable monthly goals. This gets you in the habit of saving regularly and gives you momentum to build positive saving habits. Once you feel confident about hitting your smaller monthly goals, slowly work your way up, increasing your deposits over time. Try putting something away, even if it is a little bit at a time. Also, be systematic and consistent about it – whether it is daily, weekly, or monthly.
Take Advantage of One-Time Savings Opportunities
Birthday gifts, tax refunds, and bonuses can also help in your pursuit of building up your emergency fund. Unless you are using them to pay down debt, using these funds to build your emergency savings is often the best thing you can do. Or, possibly, use part of the funds to treat yourself and the other part to save. As we like to say, when you receive one-time lump sum funds, it is a good idea to 'bank your bonuses!'
Where Should You Keep Your Emergency Fund?
First and foremost, you should keep your emergency funds separate from your other funds. They should not be commingled with your regular checking account to avoid the temptation of using them for non-emergency purposes. Furthermore, emergency savings are best in a liquid interest-bearing account that can be accessed easily without tax or other penalties for withdrawing funds. You may need to access these funds in a pinch, so you do not want them tied up in illiquid assets or a tax-deferred account (like a retirement account), where you may incur income taxes or early withdrawal penalties. Also, you should not invest your emergency funds in anything risky, like stocks. When you need these funds, you want to be able to pull out the full amount, not potentially less, because you invested in risky investments that lost value. Some good places to keep your emergency fund safe include a checking, high-yield savings account, or money market funds.
When Should You Use Your Emergency Fund?
Having a reserve fund that you can tap into when inevitable financial shocks come about can help ease the stress of those events because you know you have a reliable source of funds, rather than needing to take on loans or run up your credit card bill. However, not every financial shock is an emergency, per se. It does not exclusively have to be a trip to the emergency room, but setting up some guidelines for yourself as to what constitutes an emergency can give you a system for how to deal with these events. There are a number of circumstances that can come up that make it worthwhile to utilize your emergency fund – losing a job, natural disasters, something breaking or leaking in your home, unexpected childcare needs, family emergencies, etc.
However, it is important to note that you should not be afraid to tap into these funds. At the end of the day, if you need the money, it is there for you to use. That said, if you need to take money from this fund for an emergency, you should craft a plan to start rebuilding it as soon as possible.
Final Thoughts
Change and uncertainty are inevitable in life. Having peace of mind and the ability to navigate difficult times is challenging for everyone. Still, doing a small amount of planning for the unexpected can make all the difference. Emergency funds help ensure financial stability, and setting one up for yourself and your family is a proactive step you can take to secure your financial future. By building the routine of setting aside a portion of your income for unexpected circumstances, you are building strong money habits and a foundation to face whatever unforeseen circumstances come your way.
To learn more about this strategy, check out the article here in Bloomberg featuring Marcus Holzberg, CFP®.
If you have questions about your emergency savings, talk with a financial advisor. You can schedule a complimentary, no-obligation call with us here!
About the Author
Holzberg Wealth Management is a family-owned and operated financial planning and investment management firm based in Marin County, CA. As your financial advisors, we serve you as a fiduciary and are fee-only, so we never receive commissions of any kind. We help individuals and families like you in the greater San Francisco Bay Area and virtually nationwide with the financial decision-making process to organize, grow, and protect your assets.
** This writing is for informational purposes only. The author and Holzberg Wealth Management do not guarantee or otherwise promise any results that may be obtained from using this report. No reader should make any investment decision without first consulting their financial advisor and conducting their own research and due diligence. These commentaries, analyses, opinions, and recommendations represent the personal and subjective views of the author and do not constitute a recommendation, offer, or solicitation to make any securities transaction. The information provided in this report is obtained from sources that the author believes to be reliable. External links to third parties are being provided for informational purposes only. Holzberg Wealth Management is not affiliated with the third-party websites linked to, unless otherwise explicitly stated, and does not constitute an endorsement or approval by Holzberg Wealth Management of any of the third party’s products, services, or opinions.