This is the first of a series of seven posts titled the 7 Deadly Sins of Personal Finance. In the next week, I’ll discuss seven mistakes I think we must avoid if we’re going to be successful managing our money. They’re things I’ve learned the last few years as both a personal finance blogger and manager of my own money in our ever changing world. Hopefully you can both take something away from these and give me your own take on the points I bring up.
Without further ado, the first deadly sin of personal finance is…
Not Having An Emergency Fund
An emergency fund is a fund that you set aside specifically to handle the unforeseen emergencies in your life. Some save as little as three months of expenses, others save as many as a year’s worth of expenses, we are going with six months plus adjustments for extenuating or mitigating circumstances. Currently our emergency fund is at six months with no adjustments because we have two incomes and that mitigates the risks brought on by a slowing economy. If we were single income, I might adjust that upward to seven or eight months. If we had kids, I’d adjust it to a full twelve. It’s better to be safe than sorry, you won’t lose much, especially in this economy, by having too much in your emergency fund.
Why is an emergency fund important? When you have a pot of money set aside for emergencies, you don’t need to rely on loans or credits to pay for the emergency. A prime example is a simple flat tire in your car. A flat tire can happen any day and, while not catastrophic, can cost you anywhere from a hundred to two hundred dollars. If you have an emergency fund, you can pay for the service without worrying about adding to your existing debt. With an emergency fund backing you up, you don’t have ride on your donut spare tire (very dangerous!) until your next paycheck.
A flat tire is easy, what about something bigger? Sticking with the car theme, let’s say a rock cracks your windshield when you’re driving to work. Windshield replacement is a little more expensive. With an emergency fund, you can quickly pay for a repair or replacement that can prevent further emergencies down the road. Driving with a cracked windshield is extremely dangerous and with an emergency fund you can take care of those problems quickly and before they develop into bigger problems.
How should you save? This is the easy part. The first step is to budget and figure out how much your monthly expenses are. If you don’t have any empirical data, here’s what I’d do. First, get a ballpark estimate of expenses by calculating what 75% of your pre-tax income is. Use that as your expenses numbers for the first month while you collect data, then replace it with the actuals once you have them.
The best place to save is to open a high yield savings account at an online bank and set up an automatic transfers each month from your checking account. Don’t put it in the stock market, don’t put it in any other investments, and don’t leave it in your checking account where it won’t accrue interest.
That’s it! And like that, you have an emergency fund. If you didn’t have one before and you’re now worried your fund is small, don’t worry. You have a plan in place now and it’s just a matter of time before the savings accumulate. In the event that you do experience an emergency before the fund can handle it, you’re no worse off now than you were before you started the fund. Handle it as you would’ve but keep following the plan.
One last bit of advice: Don’t spend that fund unless it’s on a true emergency. I’ve heard of stories where people have stumbled on a “great investment tip” and raid that fund (you should set up an opportunity fund for that). Don’t. The purpose of that fund is to make sure you don’t fall down a deep deep hole because of one simple financially focused event.