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Are you struggling with how to create an emergency fund? I admit, it can seem like a daunting task, but, it can be easy! To be sure, if you want to start your emergency fund, you need to prioritize it.
Creating an emergency fund is done in two simple steps. Step 1: Generate a monthly surplus. Step 2: Move that monthly surplus to the emergency fund until it’s sufficiently funded.
Chances are if you reached the page, you’re wondering how to create your emergency fund. If you don’t have an emergency fund yet, now is the time to set one up, even if you haven’t budgeted for it. Every emergency is defined differently, but let’s define an “emergency” as a situation where we are not planning for a specific time, loss of employment, or a medical emergency.
How much should my emergency fund have?
Some experts agree that you need to put at least $1,000 in cash, stashed away in a savings account. This cash can’t be touched, unless there’s a big emergency. But, for the average person, how long will $1,000 go?
The recent COVID-19 Pandemic has exposed the cracks in our financial lives. For some of us, the cracks are disastrous. And yet, for others, it’s not the end of the world. To be sure, it all comes down to the emergency fund.
The emergency fund you create needs to cover six months of expenses. And, if you are self-employed, I would say you need twelve months of expenses. No, your emergency fund doesn’t need to be 6-12 months of income, just the “needs” expenses.
Needs are examples like rent/mortgage, food (Not restaurants), utilities, and medical expenses. Sure, if you are drowning in debt, creating an emergency fund will be infinitely more difficult. For this article, I’ll assume that debt isn’t the biggest problem.
Related Read: How to Improve Your Credit Score
How to Create An Emergency Fund
Not sure how to get a monthly surplus? The easiest way to generate a monthly surplus so that you can start creating your emergency fund is to have a budget. And, if you don’t already have a budget, you can easily create one by downloading one of ours here.
Once your budget is in check, focus on your monthly surplus. To be sure, in order to go create an emergency fund, you need to spend less than you earn.
Generate A Monthly Surplus
The first step is to generate a monthly surplus. Your monthly surplus is the amount of money left over at the end of the month. It’s your total income minus all expenses. While for most people, it will be a negative number (I.e., spending more than you earn), you can improve it!
What to do with your emergency fund?
The emergency fund you create should be in cash. It can be invested, but only in something highly liquid (quickly sold), and 100% guaranteed like a CD or GIC.
My preference is to hold my emergency fund in cash within a high-interest savings account. At the time of this writing, I’m getting just about 1% on the money, but it’s okay. To be sure, the emergency fund is kind of like an insurance policy.
It’s important to note that having easy access to the emergency fund might be a double-edged sword. For example, you might get tempted to dip into the emergency fund when there’s not enough to pay the bills. DON’T!
If you find yourself in a situation where you do not have enough money to cover all your bills and expenses, find another option. For example, you might be able to defer the payment. Or, you will need to work to increase your income.
Regardless, if you don’t have an emergency fund now, it’s time to stop all your extra spending (on “wants”) and start saving now.
Should I Invest my Emergency fund?
The emergency fund you create should generally be in a savings account that isn’t touched (unless there’s a big emergency). A big emergency is something like a loss of employment, a significant medical issue, or something that happened to your home.
You should not invest your emergency fund in anything that might decline in value. For example, stocks or ETF’s are a bad place to invest in an emergency fund. To be sure, this money needs to be available on short notice if an emergency comes up. And for all of those who had their emergency funds in ETF’s in March 2020, they would have seen their fund plummet.
Can I Use a Credit card or Line Of Credit As an Emergency Fund
Using a credit card or line of credit as an emergency fund can be a short term way to have emergency access to cash. In any event, the credit card or line of credit would need to come with a very low-interest rate.
A low-interest rate is in the range of the banks’ current prime rate plus a spread of (often) around 3-4%. The line of credit should be unsecured (not a HELOC or secured to an asset). Ask yourself, if your home secured the line of credit, and you couldn’t pay it off, the bank could sell your home!
If you have high-interest debt (i.e. anything above 10%), that debt needs to get paid off first. Yes, pay off the debt before creating the emergency fund.
I prefer to borrow using a line of credit to buy assets. The emergency fund exists to fund unexpected expenses. As a result, I wouldn’t recommend it as a long-term solution.
Final Thoughts on an emergency fund
Creating an emergency fund is one of the fundamental steps on your path to financial independence. When, I wrote my book, The Financially Independent Millennial, I said that this was one of the fundamental mistakes early on. Your emergency fund needs enough that it ensures you will be able to weather the storm, such as loss of employment, recession, or even a pandemic!