2020 has shown why we need an Emergency Fund
According to the publicly available data over 610,000 individuals filed for bankruptcy in the United States in 2020. Every year, more or less the same number of people file for bankruptcy and a large number of these bankruptcies occur because of poor personal financial management skills. Most of these bankruptcies can be avoided simply by adopting good personal financial habits, one of which is setting up an emergency fund.
What is Personal Financial Management and what does it have to do with an emergency fund?
Personal financial management is an important concept that is grossly overlooked in our society. It is a concept that is essential for the attainment of personal financial goals. Most people, as mentioned above are not aware of good financial habits, as a result they end up overspending and taking on more debt than they can manage. This eventually results in worsening of the credit and bankruptcy.
All of this can be simply avoided with good financial habits, which it has to be said are not easy to internalize. This is why in an ideal society, personal financial management skills should be taught from a young age to children, so that by the time they grow into responsible adults they have internalized good financial habits such as budgeting, keeping the savings and spending rates under control and planning ahead for the future, in order to avoid taking on financial strain. Because financial discipline is not inculcated among children from a young age, people end up making bad financial decisions that result in bankruptcies and financial strain.
Personal financial management comprises of the following elements
- Budgeting
- Saving
- Spending
- Investing
Each of these elements has further components that have to be learned and internalized, to bring financial discipline in life. In this article we are going to focus on one such component that is a part of Savings and having an emergency fund.
Emergency Funds
Before we discuss emergency funds, let us briefly discuss the saving function. The take home income can be divided into two main parts, namely
- Spending
- Saving
You can either spend your income or save it. The average saving rate in the U.S hovers between 10% and 14%, however the Covid-19 induced lockdowns pushed the savings rate up to almost 35% during June-July in the USA. Other countries also faced a similar spike in savings.
The personal saving rate can be calculated by dividing the savings with the total cash inflow of a person or a family. It has been observed that when anyone starts budgeting, their base savings rate has the potential to be increased two to three times. So if a person has a savings rate of 10%, then it can be increased up to 30% with simple changes to the budget and lifestyle. Going beyond this level requires some significant lifestyle changes, which is what FIRE enthusiasts do.
The savings can be divided into two main categories.
- Savings for investment
- Savings for emergency fund
Savings for investment are an important part of any financial management plan. These help individuals in generating wealth over time and meeting their long term financial goals such as saving for retirement etc.
It is important to remember that your 401(k) is going to be a major part of your retirement savings. It is absolutely vital to max out on your contributions if you have got an employer who contributes as well. Match the contributions being made by your employer because not doing so would be just like missing out on free money. You may have to cut down your expenditures as your take home pay will reduce slightly, this should not be too difficult if you have a good financial strategy in place already.
Savings for emergency fund are an integral part of any financial management plan. These savings serve as a financial buffer in case of any financial emergency. For instance your car can break down any time or the house can require repairs without any prior sign. Such expenditures can prove to be quite costly and at times end up increasing the burden of debt upon individuals who do not prepare for such contingencies beforehand.
Keeping the current spike in unemployment in mind, the need for emergency funds has increased because for many people emergency funds can be the last straw between sleeping on a warm bed and homelessness.
The importance of an emergency fund thus cannot be stressed enough. Think of it as an insurance plan for the times when nothing is going according to plan. This is when the emergency fund can prove helpful.
How to set up an emergency fund?
Your emergency fund should be able to sustain you in case of a worst case scenario. Which is why it is important to set it up in the right way.
Calculate your monthly expenditures first. If you are already in the habit of making monthly budgets, then this should not be any problem for you. If however you do not make monthly budgets, then this can be a good way to get started.
If you already make a budget then the monthly expenditure limit will cover all of your expenses. If not then make sure that you include every expenditure that you are expected to incur. For instance
- Mortgage
- Rent
- Insurance
- Utility bills
- Grocery
- Any other expenditure
If you are just starting off with your emergency fund then try to aim for one month of expenditures. So if your monthly expenditures are around $4000, then this is what your emergency fund should have at the very minimum.
Try to set monthly targets to transfer a certain amount of savings to the emergency fund. The aim is to increase the capacity of the emergency fund from one month sustenance limit to 9-10 months and perhaps 12 months. This is going to be your target. You are going to start with one month and aim to save enough to last you for a whole year, without any other source of income. So if your monthly expenditure is $4000 then you will need $48000 annually.
How long it takes to save up this much, depends on your savings rate. The higher your savings, rate the faster you will be able to meet this target. It is obviously not easy to save up to $50,000 quickly, this is why emergency funds are so important. One should ideally start saving right from the time they start earning a stable income, when they do not have a lot of financial obligations.
Where to keep the emergency funds?
Once you start saving up for the emergency fund, you will need to decide where to keep the funds. Ideally the funds should be kept in a savings account. However the interest rates are at an all time low right now, so keeping the funds in a normal savings account won’t be of much use.
Try to look for high yield savings accounts. At the moment even the high yield savings accounts are offering pretty low rates compared to the past. If you do not know which banks in your area are offering good high yield savings accounts, then simply head over to BankRate to find out the best high yield savings account. You can also use CDs (Certificate of Deposit) to invest your savings, however the downside of CDs is that they require the lump sum amount to be invested without any withdrawals. With uncertainty on the rise, it would not be so wise to invest your emergency funds into a CD, at the moment.
If you cannot find good rates in a brick and mortar bank then you also have the option of trying out online banks. Online banks are able to offer higher rates as compared to the conventional brick and mortar banks because they have lower administrative costs. Thus, they can afford to offer higher rates to their clients and some online banks have got more streamlined services as compared to conventional brick and mortar banks, simply because their focus is solely on providing services digitally.
To conclude this, it must be emphasized that having a financial strategy can save you from a lot of trouble. Adopt good personal financial management habits and make sure that you set up your emergency fund before it is too late and when you do, max out on your 401(K) contributions to make the best of every opportunity coming your way.
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About Kenneth Christian:
Kenneth has over 20 years experience as a financial advisor and wealth manager helping clients nearing retirement, in retirement, clients going through a transition, and working with business owners. He works with clients virtually all over the United States.