5-Step Plan – Step 3 – The Emergency Fund
By now, if you followed step one and step two, you have a budget that, provided you can stick to it, throws off extra cash every month.
The temptation is to start paying down that horrible debt as fast as possible.
For the long-term success of your plan, however, it’s very, very, very important to build an emergency fund first.
So before you start paying down your debt, build an emergency fund. It will be good for your mental health, for your confidence and the for long-term success of your journey to a debt-free life.
Why An Emergency Fund Is So Important
Human beings are bad at measuring risk. It’s just one of those things that our brains are not adapted to. Looking to the future, you think, “what could possibly go wrong?” You’re in good health, you have a solid job, you can afford the rent. Your finances are finally on track. Why should you create a specific pot of money for “emergencies”? Can’t you just dip into your savings if something come up?
I have spoken to enough people who have found themselves in dire financial straits to know how quickly things can go south. Often, their inability to cope with a negative shock to the system was caused by a lack of free cash to be able to react quickly and decisively to an unfortunate surprise. This often causes longer-term financial difficulties that can lead to negative emotional states the further damage your ability to plan and act with financial intelligence.
A Personal, Real-Life Example
When I returned to the UK from France, I figured it would be fairly simple from a tax and career perspective. After all I was keeping the same job with the same employer, just moving from one country to another.
I hadn’t been paying enough attention.
In France, you pay taxes the year after you earn the money that’s getting taxed. (They’ve changed this recently, but it was still the case a few years ago). What this means is that if I earn €50,000 in one year, then I will have to pay the tax on that income the following year, in three or four instalments.
In the United Kingdom, there’s a scheme called PAYE, or “Pay As You Earn”, which deducts the tax you own from your paycheck before you actually receive the money.
When you move from France to the UK, for your first year in the UK, you’re paying French taxes from last year at the same time as you’re paying UK taxes for this year. It’s like getting taxed twice on your income for one year, because of the difference between the tax systems.
This blew a hole a mile wide in my financial plans.
When I figured out what was happening, I took the necessary amount from my emergency fund, dumped it into my old French bank account so the French tax authorities could get paid, and I restructured my finances in the UK to gradually build that money back up over the next few months.
The whole thing took me a couple of days to think through and sort out, and then I moved onto other things. It was like taking a loan from myself, but taking the money from somewhere where I knew it wasn’t going to affect my ability to pay my rent, or damage my long-term savings.
If I had not had the money available, I would have had to either borrow the money from a bank, reverse some of my long-term savings or call the French tax authorities to negotiate a payment plan. None of these solutions are appealing, all have slight negative emotional consequences and all of them feel like a step backwards.
Instead, I sorted the whole thing in two days. Despite being annoyed at myself for missing something so obvious, I was able to draw a line under it and not let it bother me.
Reasons To Have A Well-Funded Rainy Day Account
Because Emergencies Happen
It won’t be what you expect, because if you expect it it’s not an emergency. It will always cost more than you think, and it will always require a quick reaction. Having money to hand to deal with the unexpected allows you to be decisive and efficient. When something important happens and requires money you don’t have to hand, being able to react is priceless. It brings peace of mind and clarity. It allows you to deal with a problem without throwing the rest of your life into disarray.
Because You Don’t Want To Derail Your Financial Plan
The emergency fund allows you to react without torpedoing all your other financial plans. If you need to fly halfway across the continent to take care of a loved one, and upon your return your monthly budget is a hot mess, it will be very difficult to get back into a routine. If, on the other hand, you’ve burnt through 30% of your emergency fund but your budget is in fine shape, you’re in a stronger position. You just redirect savings into the emergency fund, all your other spreadsheets and targets remain intact and at worst you’ve delayed your financial plan by a month or two.
Because: Peace Of Mind
The emergency fund has value even if you never use it. If you live on a tight and chellenging budget. When you’re working to save money, pay off debt and become financially independent. We know that the slightest shock, the merest disruption to the careful balance we’re maintaining can knock us down. That causes anxiety. Having this cash sitting in a quick-access account that we never touch lets us focus on our budget and our lives without worrying about the “what if’s”. We know we can cope with whatever life throws at us and so we can move forward with confidence.
How Much To Save In Your Emergency Fund
We measure the size of an emergency fund in “months”, rather than cash.
If your monthly expenses are £2000, then a 3-month emergency fund would be £6000. We do it this way because the emergency fund provides autonomy in a situation where your income stops. How many months do you need to turn around in if you were to lose your job?
The lowest advisable size for an emergency fund is 3 months. I would suggest you build up to this as soon as you can. How long this takes obviously depends on how much you earn and how good you are at squeezing your budget.
If this is very difficult for you, clearly having a one-month fund is better than having no fund at all. The minimum advisable size really is 3 months though. Imagine you suddenly find yourself unable to work; one month is not really enough time to figure out your options and find yourself another income.
If you’re eager to start paying off your debts, then consider being particularly aggressive with your savings at first. At least until you’ve built up that emergency fund. Then you can start saving with security and comfort.
As soon as you are practically able to do so, I advise you to increase the fund to six months. A six-month fund is enough to deal with almost any non-medical issue that life can throw at you. Even most serious medical problems will be easier to cope with if the money isn’t an immediate problem.
When Is It Ok To Use Emergency Funds?
Almost never. The idea behind the fund is to provide security for the totally unexpected. It’s a cushion for your worst-case scenario. You absolutely cannot dip into it when the month-end is a little tricky because you’re low on cash.
Some use cases that I would consider appropriate:
- You are suddently and unexpectedly redundant and it will take you 2 or 3 months to find a new job. Don’t let the fact that you have emergency fund money to pay your bills make you too comfortable!
- A close relative has had an accident and you need to drop everything to go take care of them. You take unpaid leave and have to replace that income from somewhere.
- You’re called to an important family event and don’t have funds for the travel. (I’ve used money from this pot to attend a funeral)
- You or a family member needs an important medical intervention that is not covered by your insurance. No, botox doesn’t count.
The peace of mind it gives you to have these funds comes because they cover the critical and unexpected. They’re not there to cover things you forgot to include in your budget, or moments when your self-control slipped. In these cases, you should compensate by spending less the following month, not by eroding your emergency fund.
I’m Tempted To Skip This Step And Go Straight To Paying Down Debt
The number of people who fail in their financial plans because the unexpected happens is a big scary number.
It’s comparatively easy to stick to a budget when everything is happening as expected. Life doesn’t stay that way for long though. A debt repayment plan typically lasts many months or years, and you can’t count on everything being stable for that long.
Your ability to cope with the unexpected is a critical success factor in your debt repayment plan. So pay into this emergency fund until it has the necessary balance. Then you can move onto the next step with confidence and security.