How to Build an Emergency Fund

It’s not hard to find counselors that will tell you to use all your resources to pay off debt and not worry about building an emergency fund at first.  That advice is based on the premise that you’re paying more interest on debt than you can earn on a savings account and if a crisis arises, you can always borrow that money again and be no worse off.  While that makes sense when we purely look at the math, there is so much more to consider, especially when people are involved.  The goal isn’t just to get debt-free as quickly as possible.  The goal is to get debt-free and stay that way permanently.  One key element of that process is to replace our unhealthy decisions of the past with habits that will support the lifestyle we’re looking to live.  When debt is an acceptable option, I can almost guarantee you that it will be in your financial future.  However, when debt is considered a last resort and only used when wise counsel confirms it is the only viable option for your situation, your probability of living a debt-free life someday is greatly increased.

Anyone that has debt can do the math to calculate when they will be debt free as long as they continue to make minimum payments.  That establishes the longest it will take to be debt free.  From there, a good plan and discipline might even allow you to speed up that timeline by making additional payments.  However, as soon as we take on a new debt, no matter how small, the timeline is reset and we have a new future debt-free date that is further out than the original one.  There is no reliable debt-free date to mark on your calendar as long as new debt is an option.

Our emergency fund serves as our crucial debt avoidance plan for when life surprises us with those unexpected expenses.  We know that unplanned expenses are going to come, so we need to be prepared for how to pay them when they do.  Failure to plan ahead leaves us only one unexpected expense away from new debt, which often discourages individuals and can blow up a financial plan like a donut destroys a diet.  We have to recognize that success leads to more success and even small setbacks can put the best designed plans at risk.

How Much Do You Need?

There are a lot of rules of thumb when it comes to emergency funds.  Some experts will tell you to start by saving $1,000 and then go back to paying off debts.  Others will tell you the ultimate goal should be an amount equal to 3 to 6 months of expenses.  While these are okay for general advice, let me give you a few things to consider as you think through the right amount for you.  Most of these considerations boil down to your personal financial risks and how much it would take to cover the ones that are more likely to occur.

Risk of an income change? – The more your income varies, the greater your emergency fund should be.  There’s a big difference between the risks of a person earning commissions and the person with a steady salary.  You don’t want a bad month to blow up your entire financial plan, so build an emergency fund that helps cover the ups and downs of your income.  If your pay is steady, but your job is not very secure, you’ll also want to have a larger emergency fund to cover the higher probability of a job loss.

Is your budget stretched? – If you are barely able to pay the bills each month, you are obviously at more risk than the person that has extra income after the bills are paid.  Free cash flow is able to be used to cover unexpected costs that come up during the month.  That’s not an option for the person that has every dollar already allocated.  For that person, the emergency fund is important when trying to survive unexpected expenses.

Reliability of your assets? – Are your appliances or your car on their last leg?  If so, you have a much greater chance of needing money to cover repairs or replacement costs.  These likely expenses need to have dedicated reserves.  It’s not a matter of if that day will come, but when.

Uninsured risk? – You need to be able to cover expenses that won’t be covered by your insurance.  Know your insurance deductibles and out-of-pocket maximums in order to prepare for a possible medical expense or damaged property.  The higher your deductibles, the more you’ll need to set aside.

Once you’ve evaluated these risks, you’ll have a better idea of the amount you need to feel comfortable with your emergency fund.  The goal is to build your reserves over time, but we all need to start by establishing a minimum amount as a starting point.

Key Steps

Protect it – If you expect your emergency fund to be there when you need it, you’ll want to protect it from yourself.  If it’s easy to access for spontaneous decisions, there’s a good chance it won’t survive.  I prefer to build an emergency fund at a separate institution from my regular bill-paying account.  That makes it more difficult to go online and simply transfer some of it to my checking account to cover the monthly bills.  The more out-of-sight it is, the more likely it will survive my short-term desires.  It’s like the old story of the lady that used to keep her emergency cash frozen in a block of ice.  The idea was that by the time she could thaw it out, the momentary urge to spend it would be gone and the money would be safe.

Define its use – Let’s not forget that it’s called an emergency fund, so we need to know what constitutes an emergency.  Anything short of that definition is not a good enough reason to use these funds.

Be consistent – Just like any other savings we want to grow, we need to contribute a little at a time and do it consistently.  The best way for most people is to have a small amount direct deposited to the account from every paycheck.  It probably won’t be missed in the end, but it will certainly accumulate over time.

Capture extra income – You never want unbudgeted money to get away.  So, if you receive a bonus, a raise, or a tax refund, take advantage of that extra amount and use it to speed up your financial plan.  Part of it could be used to pay down debt or increase your giving, but don’t forget about growing your emergency fund to get it where it needs to be.

Conclusion

Remember that our financial plan is about much more than just getting out of debt.  If not, we would sell everything we own and speed it up as much as possible.  Our ultimate goal is to be good stewards and to use all that God has entrusted to us for His glory.  That can’t be accomplished with a one-dimensional plan.  It requires a process and a lifestyle.

So, if you find yourself in debt today, don’t simply look at how you can get it paid off the fastest.  Instead, build a plan to change your lifestyle and develop good financial habits that will continue on well after your last debt is paid off.  Those habits include saving up for anticipated expenses as well as ones you don’t expect.  Don’t be surprised when you have to dip into it for the things that weren’t in your plan.  It may feel like a setback, but we should really consider it a blessing that our plan allowed us to have that money available rather than relying on debt.  At those times, we can thank God for His provision and continue moving forward with our plan instead of feeling like we’re not making any progress.