What would you do if you needed to pay $500 upfront for an emergency today?
Could you do it?
How would you pay for it?
According to a survey by Bankrate, 63% of Americans do not have enough in savings to cover a $500 emergency. To pay for it, they said they would cut back spending in other areas, charge the expense to a credit card or borrow funds from friends and family.
When I look around me in London, I wonder whether the same could be said of Londoners. How many would struggle to cover an unexpected expense of $500? I also thought about whether a Londoner or American could handle an expense of over $1,000. You can earn a high income in London. That’s not to say that everyone does, but that even those who do have a high income, I wouldn’t be surprised if they struggled with a sudden $1,000 expense.
Today’s Actions, Tomorrow’s Gains
It’s the same old story. We find it hard to take action today that will have a positive impact in the future. We tend to take actions today that have negative consequences in the future. A friend was recently telling me that she had struggled to cut down on her drinking in the past. She acknowledged that regular binges weren’t good for her, but she couldn’t cut back. Then, she started tracking her drinking. She felt more in control. She used the government guidelines to determine whether she was drinking too much and used those occassions as a red flag. “I was finally using the link between my actions today and the future consequences. I always knew I wasn’t drinking a healthy amount of alcohol but it was so vague that I couldn’t really do anything about it. Being more conscious of the actions I take today makes it easy to think about what the consequences will be tomorrow.”
An emergency fund is no different. It’s an action that you take today from which you’ll gain in the future. An emergency fund is that peace of mind that if something goes wrong, you’ll be ok.
What are real life examples of an emergency?
Anything that puts your life in danger or restricts your access to the basics: food, warmth, shelter, constitutes a real emergency, for example:
- Medical treatment
- Heating and/or hot water system breaks down
- Leak in house (needs immediate attention)
- House burns down
- Car is totalled (and you live in the middle of nowhere)
An emergency fund is peace of mind that if something goes wrong, you will be ok.
How Much is Enough?
When I read other articles on saving for an emergency fund, I come across similar suggestions: save $1,000 first and then work towards saving 3 - 6 months worth of expenses. Whilst these suggestions are good starting points, they don’t offer much guidance on tailoring your emergency fund to your circumstances. You may not have enough saved or you may have too much saved meaning you’re missing out on interest. Some of us own our home, others don’t. Some of us have kids, others don’t. Some of us have more than one source of income, others don’t. And so on. Look at your life as a whole. What are the large expenses associated with your current lifestyle? To get a better idea of how much you should have in an emergency fund, consider the following questions:
1. What are your current ‘liabilities’ (your biggest long-term expenses)?
- A car
- A mortgage
- Dependents (i.e. kids)
The more of these ‘liabilities’ that you currently have, the bigger your emergency fund needs to be. You might think it’s unlikely that you’ll have an emergency with each of these all at once, but if it can happen, it will happen and you’ll never regret planning for the worst.
2. On average, each month you…
- Make your paycheck last until the next - paycheck
- Run out of money before your next paycheck
- Have money left before your next paycheck
3. What’s the worst case scenario for the next month?
- Your car is totalled
- Lose your job (or your only source of income)
- A fire burns down your home
- An unexpected pregnancy
What are the biggest expenses associated with your current lifestyle?
The exact amount you should hold depends on your circumstances but I’ve tried to match age to your situation in the table below to give you more tailored options*:
If you’re single and you don’t have a mortgage, a healthy emergency fund would be at least 3 months’ worth of expenses. As soon as you take on extra costs like a mortgage, it’s worthwhile increasing your fund for additional protection, especially if you have a mortgage and kids.
*I’ve used the assumption that the older you get, the more you’ll need in an emergency fund. You may not believe you wish to have kids, but there are plenty of cases of accidental parents - even in your 40s. There’s also the consideration of declining health which means higher medical bills if you don’t have a government-run healthcare system.
When to Use an Emergency Fund
When is the best time to use money in your emergency fund? Follow this checklist to determine whether this purchase requires funds from your emergency fund:
1) Will not addressing the issue immediately result in any of the following:
- No access to employment
- No access or impeded access to warmth
- No or impeded access to shelter
- No access to food
If you answer no to any of the above, then it’s not an emergency. If you answer yes, then answer the next few questions to avoid overpaying:
2) What’s the minimum amount I’d need to pay for minimum re-access?
If your car is totalled, could you try a car-sharing scheme like Zipcar, so that you can spend time saving up for a replacement car? Or if there’s a repair in your home, could you use a temporary measure to resolve the issue, until you’ve found a suitable long-term solution?
3) Have I shopped around for the best offer on this purchase?
It can be easy to panic and go for the first available option, but with a small amount of time investment, you could get a few quotes from different providers to fix your car or home.
4) Do I need a like-for-like replacement? (when it’s an essential item)
If you owned a 4x4 which gets totalled, do you really need a 4x4 replacement? Did you buy the 4x4 originally because you really liked it instead of it having a real practical use? Could you go for a smaller, more affordable car to replace it? After all, when you remove all of the advertising, gadgetry and functions of a car, it’s just a mode of getting from A to B.
5) If I withdraw X amount from my emergency fund, how many months would it take to replenish funds?
If I could pick one question to answer as a minimum, it would be this one. By calculating the amount of time it’d take for you to replenish the amount spent, you’re more likely to carefully consider the cost of your replacement/repair.
How to save for an emergency, if you’re living paycheck to paycheck.
Your first goal is to identify areas where you can cut back on your spending. This is the quickest way that you can create a gap between your paycheck and your expenses. Once you've cut back your spending by just $10 a month, you'll be amazed at how much easier it becomes. Then, work on increasing your income.
1. Print a visual and put in on your bathroom mirror (or any place you’ll often see it). Choose from one of the visuals to get started: burnt out house, destroyed car and a scene from an operating theatre.
2. Next, write down your expenses (or record them using an app like Spendee) for the next 30 days (or at least 7 days to begin with).
3. Work out, based on the data collected, what your average spend per month is. You should include your rent/mortgage payment, bills, groceries, basic clothing expenses and costs of running your car.
4. Subtract your average monthly expenses from your take-home monthly pay.
5. If there is no money left over, review each expense carefully and ask:
a) Does this expense add value to my life?
b) How might be life be better if I cut out this expense altogether?
Whilst I’m not a fan of corporate language, continuous improvement is important for your emergency fund. Saving in an emergency fund shouldn’t be a one-time event. Schedule in a quarterly review of your circumstances and use the guidance in this article to tweak your emergency fund.
Feature image credit: Dave Savides via Zululandobserver.co.za. Image of leaking roof credit: Auckland Roofing. Image of burning house credit: ZGossip.