This is the fourth in a series of eight articles expanding on the steps of the article:
8 Steps to Build Wealth
Step 4: Establish an Emergency Fund
Life is rarely reliable, and that’s both an upside and a downside. When it turns out to be a downside, those that have made preparations have a higher chance of weathering the storm.
An emergency fund is a collection of money that allows you to deal with unexpected problems without tapping into credit or retirement savings. Experts, as one may expect, tend to disagree on how much one should save in an emergency fund, but a common and rational answer is that it of course depends on what your life is like. If you have a spouse, children, and mortgage, you’ll be wise to have more money set aside than a single guy who could live off of ramen for a while if he had to. Some experts recommend having at least $1,000 in an emergency fund while others recommend 3 months, 6 months, or even a year’s worth of living expenses set aside. Those with responsibilities like a spouse and children should likely look to the higher end of that spectrum, whereas a young single person could likely get along with a less money stashed away. It’s good to have some of the money stored as hard cash that you can quickly access in case of an abrupt emergency, while the rest of it should be earning you interest while it waits for its day to shine.
Some people argue that an emergency fund should be set up once basic living costs are met, while others believe high interest debt should be paid off first. I advocate a bit of both but with a focus on eliminating the debt- and so reducing high interest debt is step 3 on my list while building an emergency fund is step 4, though ideally a bit of both at the same time is the wisest approach. I advocate always having at least a basic emergency fund.
Consider the two scenarios:
Scenario A is that you have a few thousand dollars in credit card debt and you get your finances in order enough to begin accumulating positive cash flow. You decide to start establishing an emergency fund with that money while your credit card debt increases with an interest rate of 15% or 20% or more. If a financial emergency occurs, you’ll deplete your emergency fund and will still have all that debt, so you’ll be back to where you started except you’ll have accumulated more debt due to interest. If an emergency does not occur, you’ll have lost a lot of value when you could have been paying off all of that high interest debt and addressing that interest and principle.
Scenario B is also that you have a few thousand dollars in credit card debt and you get your finances in order enough to begin accumulating positive cash flow. However, you decide to pay off your debt first, and begin reducing that debt load. You finally get your debt to zero, but have no significant emergency fund. If a financial emergency occurs, you’ll have to go into debt again, and you’ll be right where you started (like with Scenario A except with less accumulation of debt interest). If an emergency does not occur, then you’ll have chosen the path that maintains the most financial value to yourself.
So Scenario B has all the same downsides as Scenario A while also having more upsides than Scenario A. Both seem to have psychological advantages and disadvantages as well. Neither extreme is necessary, though. I recommend never finding yourself with no emergency fund, nor focusing all your effort on establishing an emergency fund while only making minimum debt payments.
The best bet in my opinion is to focus most your money towards paying off high interest debt, while focusing some on establishing an emergency fund. The two should likely overlap a little, as it won’t hurt to have at least some hard cash around for abrupt emergencies. I’d advocate maintaining at least a bare-bones type of emergency fund at all times.
If you don’t have any debt, or have low-interest debt, then an emergency fund will be easier to make and should of course be your primary focus if you do not yet have one.
The Secret Lies in Discipline
In addition to the practical purpose, an emergency fund also provides intangible benefits to those that make the effort to make one. Going through the process of setting aside money that you never touch for everyday use builds discipline.
If, instead, you tap into credit lines or your investments instead of an emergency fund whenever you encounter something unexpected, you’ll look back in 10, 20, or 30 years and wonder why you never built any real wealth. In addition, having an emergency fund that is separate from some general savings fund allows you to keep your spending habits in check. An emergency fund should never be used for any random purchases or entertainment and the like.
Having a dedicated emergency fund gives you a barrier against ever tapping into high-interest debt or your own long-term investments and also keeps spending in check.