In my previous post “How to create a zero-based budget” I addressed the basic steps for starting the budgeting process, but I didn’t talk much about how to prioritize your allocations. Most financial planners agree that having an emergency fund is the first step in a sound financial plan. If used properly, an emergency fund can act like a shock absorber for financial bumps and pot-holes. Rather than letting these events throw your budget off course, you can take them in stride. A short-term emergency fund will help eliminate anxiety about having enough money in your account or the timing of inflows and outflows. The goal is maximum peace and control with minimum effort.
A short-term emergency fund can:
- Prevent major budget disasters
- Help you prevent fees from late bill payments, overdrawn accounts, and insufficient funds.
- Keep you out of debt when emergencies occur (or from going into more debt).
- Smooth out errors in electronic-funds processing.
- Help smooth out large fluctuations in income for those with self-employed or irregular incomes.
- Help you get a month ahead instead of always playing catch up
This post will address the benefits of a short-term emergency fund as well as how to create and manage one.
Benefits of a short-term emergency fund
1. Prevent major budget disasters
Emergencies large and small are a huge obstacle to consistent budgeting. Many go through all the effort and pains of creating a budget only to have it completely thrown off course at the first emergency. They figure that budgeting just doesn’t work and give up. A short-term emergency fund (I’ll use STEF for the rest of the post) will allow you to absorb emergencies and stay on track. In all but the most extreme situations, your budget will stay in tact and may not even change at all.
2. Prevent fees from late bill payments, overdrawn accounts, and insufficient funds.
Even with a budget in place, you still may run the risk of having more bills come due between paychecks than you have funds in your checking account to pay. One overdrawn account can trigger not only its own fee, but can cascade down the line causing late bill payment and insufficient funds fees. One occurrence can easily add up to over $100 dollars. Your STEF will make these fees a thing of the past. You will never have to worry about having enough funds at the right time. Even better, you will never pay these outrageous fees again.
3. Stay out of debt when emergencies occur (or from going into more debt).
What do you do when there’s an emergency? Most people pull out the credit card. Medical providers are also great at setting up payment plans to help you go into debt. The emotional effect of such emergencies makes you feel like there’s no use trying to get out of debt. Imagine if you were able to pay that $1,000 medical bill in cash! With a STEF in place, you can.
4. Smooth out errors in electronic-funds processing.
I’m a huge proponent of automatic and electronic payments. However, with the blessings of technology come some occasional curses. Errors in payment processing due occur and are not all that uncommon. They are usually fixed quickly. But if your direct deposit was a few days late and your mortgage payment occurred the next day, you could be in trouble. With an STEF in place, you won’t even notice these glitches.
5. Smooth out large fluctuations in income for those with self-employed or irregular incomes.
I’ve had many comments asking how to budget on a self-employed or irregular income. While I plan on addressing this issue more closely very soon, creating an STEF should be your first step. The more your income fluctuates, the more important an STEF becomes. Your STEF will absorb those months when income is lower than usual and can be replenished when your income is higher than usual. Budgeting will be easier to manage and much less volitile.
6. Get a month ahead instead of always playing catch up
Essentially, an STEF helps you get a month ahead of your expenses. Instead of ending the month with close to a $0 balance in your checking account, you will always have a buffer of hundreds or thousands of dollars. The STEF will help eliminate anxiety about whether there’s enough money to pay the bills or if you’re going to bounce a check. Without the STEF in place, you will have these worries even if you’re budgeting correctly.
A short-term emergency fund should be the first priority in your financial strategy
A short-term emergency fund is so important, it should be your first financial priority, even before savings, retirement, and debt reduction. I’m NOT necessarily saying you should stop your 401K to build an emergency fund. I AM saying you should divert as many liquid funds to your STEF as you can.
What is a short-term emergency fund?
A short-term emergency fund should consist of 4 weeks of expenses not including savings, debt-reduction, or other expenses that could be put-off or skipped in case of an emergency. With an initial budget in place, you should have a pretty good idea of how much this is. Imagine you had an emergency and you lost your income for a month. How would your spending change? Which spending categories would you eliminate? Your STEF should only cover those expenses that you would still have in an emergency situation. My wife and I have debated if you should include only necessary expenses or all expenses. I truthfully don’t think it really matters that much. JUST START! Calculate only the necessities and save that amount first. Once you reach it, you can decide if you want to save enough to cover all expenses. Even a small or under-funded STEF can provide the benefits outlined above, so it’s most important just to start as soon as you can!
Ideally you should also have a long-term emergency fund but it will take a lower priority. Other things, like paying off debt and saving a consistent amount for retirement, should take precedence over a long-term emergency fund. I will address the long-term emergency fund in a later post.
How to use a short-term emergency fund
Your STEF should reside in the main checking account you use to pay your bills and expenses. If you have multiple accounts from which you pay bills, split up the short-term emergency fund and put just the amount you need in each account to pay one month of expenses from that account. For example, we pay our mortgage from a separate checking account because we got a better rate on our mortgage. We ONLY pay the mortgage from this account so we placed an amount equal to the mortgage payment as a short-term emergency fund in that account. I hate that we were forced to use a separate account because it’s a hassle to manage and keep track of, but if you have a similar situation at least you’ll know how to deal with it. Ideally you should pay all your bills from one account for the sake of simplicity.
Rules for managing your short-term emergency fund
There are a few rules you should follow in building up and managing your STEF.
- Get a STEF in place as quickly as humanly possible.
- The STEF is not a “blow” fund. ONLY spend it on emergencies!
- When used, the STEF should be re-funded as quickly as possible.
Let’s cover each rule in more detail
1. Get a cushion in place as quickly as humanly possible
Do your best to save your STEF AS FAST AS YOU CAN. Using cash for your out-of-control categories will hopefully result in some extra savings which you can divert to the STEF. I would even temporarily divert other long-term savings, assuming they are easy to re-direct and wouldn’t require extensive paperwork. With enough focus, many people can save a full four weeks of expenses within 2-3 months.
2. The STEF is not a “blow” fund. ONLY spend it on emergencies!
The STEF is NOT a blow fund or a cushion used for month-to-month budget errors and oversights. The STEF should be used ONLY for emergencies. If you’re self-employed the STEF may also be used to cover your expenses if you have an unexpected low-income month.
Emergencies might include:
- Not receiving expected income on time
- An unexpected period of unemployment or under-employment
- A Car breaking down
- Unexpected illnesses or injuries
- Travel expenses due to a funeral
- Unexpected household expenses (the fridge or air-conditioner break)
- Traffic tickets (ok, my wife might disagree with this one)
- An unexpected tax burden (this should ideally be avoided with good planning but…things happen)
Emergencies DO NOT include:
- Planned car maintenance
- Expected or small medical expenses
- School supplies
- Unexpected expenses under $100 that should be covered by your monthly “cushion” budget category
Is it an emergency?
Some scenarios may walk the line between an emergency and a planned expense. For example, you know your car will probably break down at some point but it’s very difficult to predict WHEN and HOW MUCH it will cost. How you deal with this is up to you. You may want to start a “car replacement” or “car repair” budget category. Or you may decide to rely on the STEF when your car breaks down. I like having a “car repair” budget category that can be used to purchase a new car if I don’t have any major repair costs.
Create an “Emergency Rules” list
Creating an “Emergency Rules” list will help you decide ahead of time what you consider to be an emergency. Think about some of the “gray area” expenses and decide how you will react. You can use the lists above as a starting point. An “emergency rules” list helps you prevent deciding in the moment and calling something an emergency expense that shouldn’t be. If you are married, the list will be an argument-prevention device. You can negotiate while you’re calm and collected instead of waiting until an emergency occurs and you’re both stressed out. My wife and I have used our list many times and continue to revise and refine it every few months.
3. When used, the STEF should be re-funded as quickly as possible.
The last rule for your STEF is that, when used, it must be re-funded as quickly as possible. One danger is that you’ll use the STEF as an excuse to spend irresponsibly or unco\nsciously. If you spend more than you planned in a month it’s easy to say, “it’s ok, we have enough money in our account.” Before your know it, the STEF is depleted and you’re back at square one. To prevent this you must religiously account for your STEF every month. If you use it, replenish it as soon as possible. Because emergencies are typically large expenses, it may take a few months to fully replenish the emergency fund. But at least it will have prevented you from going into debt.
As I mentioned, even a small, under-funded short-term emergency fund can provide you significant benefits. The sooner your start building your STEF, the sooner you can lower your stress and smooth out your financial journey. Please leave a comment with your thoughts. If you have a short-term emergency fund already, share your experiences.
Be sure to TELL A FRIEND about GFD! I want to help as many as I can to obtain stress-free financial control and meet their financial goals.
Posted in Budget, Budgeting, Emergencies, Personal Finance | 18 Comments »