Phase 2: Emergency Fund

If you successfully made it through Phase 1 by cutting your monthly spending by 20%, this step will be easy.  Why?  Even if you had been spending every cent of your paycheck and not saving at all, when you reduced your spending by 20%, you automatically increased your savings.

Let’s say you used to spend $3,500 per month.  You completed Phase 1 and successfully shaved 20% of that down so now you spend $2,800/month ($3,500 x o.8).  You’ve got an extra $700 per month floating around.  With your new baseline spending level of $2,800/month, it would take you 12 months to fully fund your 3-month emergency fund ($700 x 12 months = $8,400 which also equals $2,800 x 3).  That’s it!  Twelve months!  The beautiful thing is, no matter your income, if you cut your spending by 20%, it will only take you 12 months to stash away 3 months of living expenses.  That is only if you weren’t saving anything at all before.  If you were already saving, you’ll get your emergency fund up and running even faster.

Case Study: Why You Need and Emergency Fund

Consumerist spending habits aside, two of the most common reasons that people get into serious debt is for medical expenses or job loss.

Let’s run some quick numbers.  Let’s say your baseline spending level is $4,000/month and you get laid off.  You have no emergency fund, but you’ve got a high-limit credit card to get you through unemployment.  You apply for unemployment immediately after your layoff and start receiving a $240/week benefit after three weeks (which is typical for a $55,000/year salary).  You’re lucky to find a job within only two months and it pays the exact same as your previous job.

In the meantime, you had to spend $8,000 to live.  Unemployment took awhile to kick in and you received it for a total of 5 weeks which equals only $1,250.  So you put $8,000 – $1,250 = $6,750 on to your credit card which charges 18% interest (typical).

How much does your unemployment end up costing you? Well, you originally needed $6,750.  Then you end up making a $180 payment on your credit card until your debt is paid off.  Credit card interest comes out to…. over $3,000.  So your layoff cost you $6,750 + $3,000 = $9,570!!

Like you, I initially didn’t believe this.  I had to have made a mistake.  I checked and rechecked. Used different credit card calculators.  If you don’t believe me, run the numbers yourself.

In an alternate universe, you had three months of living expenses.  The math here is easy.  You needed to spend $4,000 per month.  You had 3 months x $4,000 = $12,000 in a savings account.  Your lay off cost you exactly $6,750.  You still have money left over!

Automatic Transfer to Rule the World

Those extra savings you made from Phase 1 need to start going somewhere useful immediately.  Don’t let it just sit in your checking account.  Don’t take it out as cash and put it in an envelope.  Open an online savings account and start sending it there.  Automatically.

Many of the best savers use automatic transfers to streamline their savings habits.  Why?  You don’t have to think.  Saving is insanely easy when it happens automatically.  Not only are you are less likely to spend money that isn’t there, but you also don’t have to worry about saving.  Reducing worry is our end goal.

An Exception to the Three Months Rule

There is one legitimate reason to not fully fund a 3-month emergency fund:  non-mortgage debt.  If you’ve got student loan, medical, car, or credit card debt it is ok to only have one month of living expenses.  Why?  We want you to pay off that debt as soon as possible and aggressively as possible.  Paying off a credit card that has 18% interest is going to save you a ton of money and will make saving up for that emergency fund even easier once it is paid off.  We’ll go over this a little more in Phase 3.

Action Items

  1. Use BankRate to select an online savings account (not a money market account).  Open one today.  It takes no more than 10 minutes.  This account should have four requirements:
    • No annual fee
    • No minimum balance
    • Must rank among highest in APY
    • FDIC insured
  2. Get with your payroll department and start direct deposit to your checking account.  Your paycheck (after your 401k, health insurance, etc.) should all go to your checking account so you can manage your automatic transfers from one location.
  3. Set up a recurring, automatic transfer to take cash from your checking account and ship it off to your emergency fund.  Send away as much as you can handle.
    • Having your checking and savings through the same bank makes this very easy, but don’t sacrifice terrible interest and fees to maintain a relationship with your crappy bank.

The emergency fund is a staple of personal finance.  An ounce of prevention here will save you a pound of cure later.  Three months of actual living expenses is the minimum (one month if you’re aggressively paying non-mortgage debt).  If you have six months stashed away, you’re even better prepared.

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