A critical question in everyone's financial life should be how to build an emergency fund. An insufficient emergency fund is a key cause of financial stress as evidenced in the findings of the 2019 PricewaterhouseCoopers (PwC) Financial Wellness Survey (1). For the past eight-years the large accounting firm has conducted surveys across groups of 1,500 employees to hone in on financial stress and wellness. The 2019 survey found that 54% of those polled who make under $75,000 per year, and 44% of those making over $75,000 per year, specify an insufficient emergency fund is their top financial concern. That’s half of us.
I can attest to the findings personally. My clients overwhelmingly cite not having a large enough emergency fund as a key worry - irrespective of whether I work with clients in my current city, Stowe, Vermont, or my original hometown in Frederick, Maryland. Both states differ drastically in demographics and economic affluence. Both regions pose distinct hurdles for my clients to work through. Yet, one common theme is the financial stress stemming from not having a large enough emergency fund. It’s not discriminating. This stress even takes precedence over saving enough for college and retirement, just as the 2019 PwC survey found, as well, which is odd because the advertising focus of financial companies is centered around retiring and education solutions. So, the question now is how to build an emergency fund.
Building an emergency fund, or building a broader emergency strategy, is a critical skill to know. An emergency fund is the “shock-absorber” in one’s financial plan that helps handle unexpected life events. We all get hit with a life event. What varies is the magnitude of the event. Like a shock absorber, an emergency fund helps the family flex to absorb the impact, and then provides the rebound to level back to normalcy.
The key to building and maintaining a sufficient emergency fund is developing a process that identifies where money is going. We can’t tell our money where to go, until we understand where it went!
Before I outline how to build an emergency fund, I'd like to briefly explain what I find that does not work.
1) Applying a little time and effort to solve the problem. There is a tendency to find an easy solution to a habit that's been formed over many years. Think of all the ways money leaves our hands - cash, debit cards, credit card subscriptions, on-line bill-pay, and the list goes on. It takes a bit of discipline and dedication initially to develop a catch-all process; and, if you are married, even more communication and consistency.
2) Relying solely on Budgeting Apps. Budgeting Apps are convenient, and therein lies the problem. An App cannot stop something from being bought. They often turn into fancy tools that show us that we are overspending. They do not correct poor habits.
3) Setting a monthly budget. Don't get me wrong, a monthly budget is better than nothing, but a monthly budget tends to be something people sit down to visit once a month. That's too infrequent. Think of it this way. If you have a goal of getting fit, and just worked out one day a month, you probably would not see your desired results in the long run.
4) Making all purchases on a credit card. Unless the purchases are paid off weekly, and there is a notification system to keep you informed of all purchases made, this process does not work. So many people chase a perk offered by the credit card company, while so few people walk away ahead. They would only offer that perk if a majority of their clients did end up paying for the perk in some manner.
As I mentioned, it is most beneficial to have a process when learning how to build an emergency fund. The process outlined below is one that takes you from high-level concepts then drills down to specifics. It is a process to form both a budget and a cash-flow management system, so you can understand where your money is going.
First, go through the last six months of expenses and identify how much was spent on various items. It's good to get a monthly average for each expense type and multiply that amount by twelve months. Be sure to include taxes and expenses, such as health care, which come off of your paycheck. You want to know where every dollar is going.
Second, determine how much of your gross annual salary is being captured. I prefer to categorize all expenses into five broad categories and then deduct those amounts from gross income. This categorization helps find opportunities to adjust or redirect spending. The table below is an illustration of how to categorize money flowing through a household. Sorting a detailed list of expenses into these categories will help you compare against the suggested baseline. Note, not all households face the same taxes and expenses. This baseline is a guide for comparison purposes - not a concrete target for one to meet.
Third, create a list of expense amounts sorted by due date. The idea is to have a list showing how much money is expected to come out of the household each week of the month. Most households face a condensed window of time, typically from the first to the 10th of the month, where many bills are due. This can cause the family to feel "cash poor" during one pay-cycle, and "cash rich" during the other. This is an issue because there is a tendency for the family to seek enjoyment later in the month after feeling like they had less money to spend during the first half of the month. The process of making this list helps to see how the expenditures stack up.
Fourth, form two monthly budgets from the expense list. One budget covers the 1st through the 15th of the month, while the second budget covers the 16th through the end of the month. Try to equalize the two budget period as best as you can, even if it requires an early bill payment. Most people receive equal paychecks, so the more you are able to equalize the two budgets, the better you will be at avoiding the "cash-poor/ cash-rich" dilemma.
Fifth, identify all expenditures you can easily make with cash. Purchases such as gas, groceries, dining out, and entertainment are the most common. Some people may want to be more granular and include coffee, lunches, or adult beverages. The key here is to determine a weekly amount of cash to put in your wallet at the beginning of each week. Discipline is needed to keep these expenditures in focus, and cash in the wallet is the easiest reminder. If you are married, you and your spouse may have different weekly amounts depending on who performs different functions, such as grocery shopping.
The fifth step is critical. It's a "hard/easy" action. It's hard to do, but will make your life easy if followed. These purchases tend to be areas where we make more impulse buying decisions, drift over budget, and then forget the next week what we did. Paying in cash adds a physical action, or reminder, to keep an eye on one's weekly allotment. This is not the case when purchasing with a debit or credit card.
Last, have a weekly reminder to perform a budgeting checklist. I use my smart phone. Every Friday, a reminder comes up to do my budgeting checklist. The checklist includes a few bulleted items like, "pay off credit card purchases this week", "plan for upcoming unexpected expenses (such as a school field trip notice)", and "list the things that threw me off budget this budgeting period." The work takes no more than ten minutes and the reminder is the key to staying engaged in the budgeting process.
The process thus far has taken our household cash flow from high-level identification to organized expenses in digestible time frames to managing purchases on a weekly basis. We now have "guardrails" on our monthly household income, now it is time to build the emergency fund.
If you finish a budget cycle (the 15th and end of every month) with "extra" money, move any remaining money in your bank account into your emergency fund. If on the 15th of the month, for example, there was $250 in your checking account before the paycheck deposit, move $250 into your emergency fund. Get it out of checking and away from the temptation to spend.
When you finish a week with cash in your wallet, which happens very frequently, take less cash out the following week. For example, if you take $100 per week for the weekly expenses and finish the week with $15 in your wallet, take $85 out the next week. Stay disciplined and you will see this potential savings appear in your bank account at the end of each budgeting cycle.
If you are a person who is paid every two-weeks, or in twenty-six pay periods instead of twenty-four, the same process will work. There will be two months of the year where you receive three paychecks in a month. This process provides an opportunity for these extra paychecks to transfer to the emergency fund.
1. Develop several savings accounts. I use my bank's on-line portal to create extra accounts for savings, period expenses, kids, vacations, and heating (if you also live in northern Vermont, you understand that expense category). The basic idea is to assign a job, if you will, to each account to help you stay organized.
2. Give each individual account a unique name to help you stay focused. For example, I have an account for periodic expenses, such as homeowner's association dues, water bills, life insurance, and car repairs. Let's say these expenses are budgeted at $6,000 per year. I named the account, "Periodic Expenses $500 per month." By the same token, the emergency fund could be named "Emergency Fund $650 per month." The idea is to name the account with the monthly amount you plan to add so it is easy to remember. This works especially well with couples trying to stay on budget.
3. If tempted to make a discretionary purchase, wait one day. A marketer's job is to entice one to take money out of their wallet when they otherwise weren't expecting. Waiting at least a day to make an "I want that" purchase often quells the actual desire to purchase.
4. Use on-line banking to set automatic "bill-pays" to a credit card right when a subscription or membership fee linked to the credit card is charged. If Netflix is billing $11 on the 10th of the month, set the bill-pay to pay it off immediately. There is nothing that says you can't pay credit cards multiple times per month.
5. Find an accountability officer to help you stay on task. Maybe there is a family member or co-worker striving for the same goal of building an emergency fund. If not, find a professional, such as a financial advisor, who is willing to coach you through the challenges and who will check in with you on your progress.
6. Treat the budgeting process to build an emergency fund as a practice. It took a lot of time forming financial habits that may not serve you; and it will take a lot of practice to instill new habits. Budgeting is an art. There will be months where unexpected events happen that derail you. Be gentle with self-judgment and know that your intention to budget and build an emergency fund is better than not working towards one at all.
As you learn how to build an emergency fund, you will realize there is no one-size-fits-all approach and every approach takes discipline. However, with all the techniques I have seen people use, I can safely say there is effort up front, and that effort eventually saves a ton of worry and work in the future.
(1) PricewaterhouseCoopers 2019 Financial Wellness Survey
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