The best way to avoid charging emergencies to your credit card is to build an emergency fund. You may have also heard of a “rainy day fund” or a “God only knows fund.” They are all the same, and there are some important lessons to understand when building your own.
Not “If” but “When”
At some point, an emergency will happen to you. It’s not a matter of “if” but “when.” Your company lets you go. You get a flat tire. The kids bust a window. The air conditioner stops working in July.
Although it is impossible to predict emergencies, you can still plan for them. Unfortunately, many families get caught off guard. They use credit cards, payday loans, or pawn shops to get out of a bind. It starts a terrible cycle that is hard to escape.
Tyler Perry narrates a free video called, Spent: Looking For Change. It is a documentary and is only forty minutes long. It follows a variety of individuals and families. You learn about the struggles they have encountered in the past couple of years.
I recommend the film because it shows how regular people get stuck using debt to survive. You will see how hard it is to escape a spiraling debt cycle. It’s heartbreaking to see the courage needed to keep fighting.
Their stories start with someone getting sick, losing a job, or creating a business. Soon enough, the bills get so big there isn’t any money left in the bank.
Their only options are to use payday lenders or credit cards. Now the next set of bills is bigger. Then they need another payday loan or credit card to pay those bills. And the bills get bigger again.
The subjects of the film aren’t bad people. They are working and trying to pay the bills like you and me. They just get caught in a bad spot.
I tell you this to scare you–a little–into making your emergency fund a priority. Start it today or start it tomorrow. Please, just get started.
The rule of thumb of how much to have in your emergency fund varies. I like the idea of three to six months of expenses. Try to answer, “How much do I need to survive for three months?”
To choose how many months to save up, think about how fast you could get a new job. If you can get rehired right away without moving, three months might be okay. If you need to move to a new town or a different state, six months might be a lot more comfortable for you.
If your spouse is working, plan for the emergency fund to cover the whole family in case you both lose your jobs. You should still consider how soon you both could get another job.
The bright side of two incomes is you can stretch an emergency fund. A six-month emergency fund could last a whole year if you lose only one income.
The right number for you can also depend on the type of job you have. I know a real estate agent who has an entire year saved up. The last housing crash scared him and he focused on building a larger safety net.
You also want to avoid having too much in your emergency fund. I had a client who wanted to have $250,000 in a savings account. For his family, the account would have been two years of expenses. I believe that would have been too much. A lot of the emergency money could go towards a college or retirement fund.
A Quick Warning
You may be thinking that putting any cash in a bank account is a waste and you should invest the money instead. I only have one warning. It is harder than you might think to get money out of an investment account.
When you trade securities, there is something called a settlement day. It is usually (not always) three business days after you buy or sell a security. For example, let’s say you sell some shares of stock on the Thursday before Labor Day. Your money isn’t available to move until the Wednesday after Labor Day. The weekend and holiday push the settlement day well into the next week.
It is still possible to pay for emergencies by selling investments, but you don’t want to be in a hurry. If you need money to pay for something today, it is better to have money in a checking or savings account. True emergencies don’t wait for settlement day.
If you are now convinced to get started building your emergency fund, here are the steps:
1. Figure out how much it costs you or your family to survive a month.
2. Decide on how many months of expenses (3-6 months) to save.
3. Pick a day you want the emergency fund to be full.
4. Calculate how much you need to save each month until that day.
5. Create an automatic transfer so you don’t fall behind.
Good luck, and be sure to check out more of my articles for more tips and advice.