An Emergency Fund is simply a pool of money set aside for unexpected emergencies. Once you have stabilized and your monthly net cash flow is consistently positive, your first goal should be to establish an Emergency Fund. When it comes to building generational wealth, your Emergency Fund is a foundational element. Without this foundation, you will not be able to continue the process of building generational wealth.
Why Is An Emergency Fund Important?
The answer to this question may seem obvious, but in my experience, many people, even those with lots of money, neglect their Emergency Fund. The main reason to establish an Emergency Fund is to avoid taking on debt like personal loans, credit cards, or the worst of them all: payday loans. Unexpected emergencies can and do happen all of the time. Cars need to be repaired. Roofs need to be fixed. Heaters need to be repaired. Family issues need to be resolved. New computers need to be bought. I could go on, but there are all kinds of emergencies that can occur to us.
The question is: when that emergency arises, will you be paying the bill with debt or from your savings?
If you have little to no Emergency Fund, you will end up paying your emergency bill with some form of debt. If you do this, not only will you have to pay the bill later, but you will also have to pay interest. Interest rates on credit cards are usually upwards of 20% annually and payday loans might have interest rates as high as 400%! Yikes! When you are forced to end up paying for emergencies with debt, you are digging yourself a hole that may be tough to climb out of. This can actually cause you to move backward in the step-by-step process of building generational wealth by forcing you to re-stabilize.
If you have an Emergency Fund, you should be able to pay your emergency bill with your savings. You could even use a credit card to take advantage of points, but then pay the bill off right away with your Emergency Fund. Having an Emergency Fund allows you to successfully deal with unexpected expenses without setting you back on your overall financial plan. You do not have to take on any additional debt, so you avoid digging that hole described above. Yes, you may have to replenish your Emergency Fund, but if you are effectively stabilized, this will just be a matter of adjusting your savings and time.
Through my experience, I have identified two types of people when it comes to maintaining an Emergency Fund. Note that these types have nothing to do with income level or wealth. The wealthy and the poor both are often split amongst these different personality types.
The first type of person frequently uses debt to pay for things, then uses their income to regularly pay off that debt. I would describe this type of person with the following chart:
While this can work and many people successfully live their lives this way, it puts you at risk when an unexpected emergency pops up. People who live this way might feel financially sound and confident, especially if they have higher incomes. However, below the surface, they are only one emergency away from falling into debt and digging themselves into a hole.
The second type of person saves money then uses that money to pay for things as they arise. I would describe this type of person with the following chart:
Try to be more like this second type of person. While on a day-to-day basis, this person might not be any better off than the first type, this person is in a much more sustainable position. An emergency might deplete their Emergency Fund, but they are in a strong position to avoid taking on debt.
Specifically, What Should Your Emergency Fund Look Like?
An Emergency Fund can take a few different shapes, but should always have the following characteristics:
Liquid – Your Emergency Fund should be liquid. That means that you should be able to access the money at a moment’s notice. Many people choose to use their savings account with their bank to house their Emergency Fund. Do not hold your Emergency Fund somewhere illiquid (i.e. CD, real estate, annuities). Liquid options include various forms of bank accounts, money market accounts, and high yield savings accounts. Remember, the unexpected emergency might require money right away, so you need to have your Emergency Fund ready to go.
Risk-free – Your Emergency Fund should be risk-free. That means that you should not invest your Emergency Fund in any risky assets. For example, you should not invest your Emergency Fund in the stock market. In the short term, the stock market can be volatile. If an emergency arises, you will have to sell your investments wherever they are at. Trust me, your unexpected emergency will not usually wait until the market is at a high before it occurs. It can occur whenever! If it happens to occur while the stock market is at a low, the emergency might cause you to sell your shares at a loss that you will never regain. While there are less risky assets than stocks, like bonds and real estate, I would even consider these too risky for an Emergency Fund. You will be able to invest and take on risks to get returns in the future steps of building generational wealth. Your Emergency Fund is not the place for that.
3-6 month’s expenses – You typically want to build up at least 3 months of expenses in your emergency fund and not much more than 6 months expenses. If you have a dependable job with dependable income, 3 months of expenses is sufficient. However, if you have either a tenuous job or variable income, I recommend 6 months of expenses. Anything beyond 6 months of expenses means that your Emergency Fund is getting too large and there may be an opportunity to invest.
Specific Designation – Whether you use your bank savings or a money market account with your financial advisor, make sure you specifically designate it as your Emergency Fund. Try not to comingle any other funds in this account. As I mentioned earlier, your Emergency Fund is foundational to building generational wealth. If possible, I would try to find a way to name the account, “Emergency Fund,” so you are not tempted to access it for any non-emergency reasons.
Now that we have discussed why an Emergency Fund is important and what it should look like, let’s actually get started on setting up your Emergency Fund.
Setting Up Your Emergency Fund
The first step is to know your numbers. First, look at your monthly cash flow statements to determine your monthly expenses. Use that number to determine the size of your emergency fund. Multiply your monthly expenses by 3 for a 3-month Emergency Fund or by 6 for a 6 -month Emergency Fund. Know your Emergency Fund number and start to use that number as a reference point. Let’s say your Emergency Fund goal is $15,000. Keep an eye on your Emergency Fund. If it falls below $15,000, that should signal you to add Emergency Fund savings into your monthly budget until you get back to $15,000. If the account grows significantly above $15,000, that should signal you to consider investing the amount beyond your Emergency Fund.
If you do not have an Emergency Fund yet, then start one up. As I mentioned earlier, consider a savings account with your bank or a money market account with your financial advisor. Bank savings is typically the most convenient option. This convenience can be a good or bad thing, depending on what kind of person you are. If you are disciplined with your money and believe you can confidently avoid using your Emergency Fund for non-emergencies, bank savings should be fine. However, if you are the type of person that tends to spend money they see in their bank account, a money market account with your advisor might make more sense. This at least forces you to reach out to your advisor to do a liquidation. Sometimes this one extra step can help you avoid using your Emergency Fund for non-emergencies.
Saving Into Your Emergency Fund
If you are stabilized and your net cash flow is positive, you should have some amount each month you can dedicate to savings. Start by setting up automatic monthly savings that go into your Emergency Fund. Remember to know your number and once you hit your Emergency Fund goal, you can turn off this monthly saving.
If you have outstanding debt and also no emergency fund, you may need to do two things at once. We will discuss paying off debt in more detail in Step 3. As long as your debt’s interest rate isn’t too high (i.e. payday loans), you should still prioritize building up an Emergency Fund. Yes, you may need to keep making payments toward your debt, but with your additional cash flow, you should focus on building up your Emergency Fund. Even though the law of interest rates might tell us to pay down debt first, we also want to avoid becoming the first type of person I described earlier who is constantly working to pay back debt. If you completely dedicate yourself to paying down debt and do not create an Emergency Fund, what happens when your next unexpected emergency pops up? You would be forced to take on more debt, thus deepening the hole you are already trying to work your way out of.
As you work toward building your Emergency Fund, you might have an emergency arise. That’s okay! Use what you have in your Emergency Fund to pay the emergency bill and continue with your plan to save into your Emergency Fund. This might be a setback in the building process but stay the course and you will eventually hit your Emergency Fund goal.
Having an Emergency Fund gives you power over your financial plan. When you have money saved, you feel more empowered in your financial decision making. You have more flexibility and more options when it comes to how to allocate your money in the future. Most importantly, it gives you financial confidence. This can help your overall relationship with money and will give you the positive attitude you need to continue along the process of building generational wealth.
This blog post is a rough draft for Chapter 2 of 10 for my Step-by-Step Guide for Building Generational Wealth. For now, each step will be in the form of a monthly blog post. I really hope to get your feedback and thoughts. After finishing the step-by-step guide, I plan to revisit each blog post, add detail, implement changes based off of your feedback and thoughts, and then publish the guide into a book. While creating a book is a daunting task, the impact that I think this book will have on my community continues to motivate me.