Building Your Safety Net: The Importance of an Emergency Fund

Posted by Financtitute on October 08, 2023 · 7 mins read

This is the fourth part of the Financial Independence Series:

  1. Understanding What It Means To Be Financially Independent
  2. Exploring the Spectrum of Retirement: From Mini Retirements to Barista FIRE
  3. Following the Money: A Beginner’s Guide to Budgeting
  4. Building Your Safety Net: The Importance of an Emergency Fund
  5. Unleashing Financial Growth: A Journey into Stocks and Index Funds
  6. Alright, So How Much Do I Need To Retire?

In the ever-unpredictable world of personal finance, one thing remains a constant necessity: the safety net of an emergency fund. Whether it’s an unexpected auto repair or a sudden medical expense, life is full of surprises. An emergency fund is your financial cushion, providing peace of mind and stability when life takes unexpected turns. In this post, we’ll delve into the significance of an emergency fund and explore how to determine the right size for your unique financial circumstances.

A Buffer Against Unemployment

Nobody wants to be unemployed but we need to be prepared for these potential events. According to Indeed it takes on average 5 months for a person to find a new job. While the amount of time can vary based on experience and demand, it is still something to take into account. When it comes to the loss of income, it’s not just the duration of unemployment that matters but also the financial commitments that continue despite the absence of a regular paycheck. Rent or mortgage, utilities, groceries, and insurance don’t pause simply because you’ve lost your job. Without a financial cushion to rely on, you might find yourself grappling with mounting stress and potential financial hardship.

An emergency fund plays a critical role in alleviating these challenges. It provides you with a financial buffer, giving you the breathing room you need to cover essential expenses while you search for new employment. With an emergency fund, you can focus on finding the right job fit or a job that pays properly rather than settling for any job out of desperation. This peace of mind is invaluable during what can be a trying time.

Snowball Effect Of Debt

We all know credit card interest rates are insanely high. Currently at the time of this post, the average rate of interest on credit cards sits at around 28% Source. Even if you are reading this at a later time, credit cards are considered unsecured debt and typically have very high interest rates as there isn’t an underlying asset the bank can seize to pay off the debt like a car or home. With such a high intereset rate, having to put an emergency expense on a credit card can start working against you. While it might start small, debt when compounded can turn into an avalanche in a blink of an eye. Having an emergency fund can protect you from starting that snowball of debt. In the moment it may seem like a relief to use credit cards, but when the dust has settled from your emergency you are then facing the large sum of potential debt that can create lasting negative effects on your finances.

Making The Right Decision Not Based On Money

“Anyone who has ever struggled with poverty knows how extremely expensive it is to be poor.”

- James Baldwin

While we can plan all we want in our budget, unplanned expenses or unplanned size of an expense can occur. You prioritize the must haves and push off things that can last a little longer such as deferred maintenance on your car or home. Delaying first signs of termites can go from a simple spot treatment to a full blown fumigation and lots of wood replacement. Another example is if you do have to buy something, you may be looking at the short term prices but not thinking about the long term viability. An example that comes to mind can be those pesky car mechanic’s recommendations to get new brake pads. You may think “ I don’t want to pay $X, I can go a little longer”. But then you are wearing down your rotors over time causing more damage to the car and well then we are back in that vicious cycle, if only you had gotten them fixed… Having an emergency fund allows you to make great long term financial decisions.

How Much Should I Save And Where to Keep Your Emergency Fund

Your emergency fund should be easily accessible when needed, but not so accessible that you’re tempted to dip into it for non-emergencies. Consider a high-yield savings account or a money market account for your emergency fund. These accounts offer modest interest rates while keeping your funds liquid and separate from your regular checking account. Determining the ideal emergency fund size depends on your comfort level and individual circumstances. Generally it is recommended to save at least three to six months’ worth of living expenses. Luckily we just built our budget in the last post so we have an idea of how much we need to save.

What Are We Doing?

My wife and I personally like to stick with a 2 month emergency fund stored in a high yield savings account in the event we both lose our jobs. Given that the chances are not likely for both to be unemployed due to our different careers at the exact same time, we could stretch that 2 month emergency fund to 4 months fairly easily if only 1 of us is unemployed. Another thing that would occur if one or both were unemployed is that we would drastically trim down our expenses as well. So while we have a 2 month emergency fund based on our normal spend, it could last much longer based on our flexibility.

As we have seen in some examples here today, an emergency fund isn’t just a financial safety net; it’s a cornerstone of your financial security. Life’s uncertainties are a given, but your preparedness makes all the difference. Whether you’re safeguarding against a loss of income, steering clear of the debt snowball effect, or ensuring you can make the right decisions beyond just dollars and cents, your emergency fund empowers you to navigate the unexpected with confidence. Remember, when you’re prepared for the unexpected, you’re better equipped to seize the opportunities that life presents.