I’m going to give you some advice I wish I had in my early twenties. It would have saved me a lot of money and headaches. I could have avoided tens of thousands of dollars of debt. The advice? Have an emergency savings.
What is an Emergency Savings Account For?
This seems like it would be a straightforward question but when push comes to shove, an “emergency” isn’t that specific. I used to have the wrong mindset. My savings account was for all expenses that I didn’t plan for. This included spontaneous trips with my friends. As you could imagine, I depleted my savings on the regular. Learn from my mistakes.
The best way I have found to keep my emergency fund in tact, is to have specific rules on when I can touch it. For me, I limited this account to these situations – losing my job and medical emergencies. So how do I go on spontaneous trips still? I have a separate savings account for the fun stuff.
How Big Should It Be?
The typical answer is 3 to 6 months worth of expenses. I don’t know about you but I’d rather know if I need closer to 3 or closer to 6. It’s a pretty big range to keep in a savings account instead of investing it in something that will make more money.
I also do a deep dive when I’m looking at my expenses. If I am tucking away $75 a month towards vacation, this is not an expense I would have if I lost my job. No way in hell am I planning a vacation while unemployed. Groceries and gas on the other hand, those get included.
To figure out where I landed on this 3 to 6 month spectrum, I used my job as a reference. If you have an entry level job in a popular field, you can probably be closer to the 3 month mark. This is because it won’t be too hard to land a lower paying job in demand if you lose yours.
If you are higher up in your field but your industry is still high in demand, you’ll have to move closer to 4 to 5 months of savings. The more you make, the harder it is to find another job.
If you have an entry level job in a niche field you might want to be around 4 to 6 months. If you have a senior position in a very niche field, you may want to have 6+ months worth of expenses saved.
Diversification of income also comes into play. If you have a day job but you also work from home doing a side business. The chances of you losing both jobs at the same time are more slim. In this case you may want to lower your savings to the 3 month mark.
Honestly, only you can be the judge on how much you feel comfortable putting aside but at the very least, you should have 3 months worth of expenses.
I know this post is about emergency funds but I needed to address this protection as well. Although I can use my emergency savings for medical emergencies, insurance can save you a lot of stress. There are two types of insurance I could never be without. Catastrophic insurance and long term disability.
Catastrophic insurance protects you from the big medical expenses like cancer or major surgeries. Without insurance, major medical expenses like these would completely bankrupt you even if you did have an emergency fund. Medical expenses are the number one reason people declare bankruptcy.
Long term disability is also very important. I always pay for the long term disability option if it is not already covered by my employer. This way, if you are disabled long term you can still receive part of your salary. An emergency fund won’t help if you are injured so badly that you cannot work any job for two years. You want that added protection.
Should I Pay Down Debt or Put Money in My Emergency Savings
This is a question I had when I was first figuring out this whole emergency savings thing. If you are in debt from an unfortunate surprise expense or from years of ignoring your finances (I was in both buckets), it’s not too late to make a change. The answer to which you should pay down first, is both. I’ll walk you through how and why.
The how is actually pretty simple. Take a look at your monthly budget. See how much you have left over after your bills and monthly expenses. If you have nothing left over, you need to start reducing your expenses wherever you can. Check out this post to learn how to optimize your bank accounts so your savings is automatic. It helped me finally stick to a budget.
Once you have your monthly number, let’s call it $100. You need to split it in half. Half goes towards extra payments on your debt and the other half goes towards your savings.
The reason you want to pay your debt down is because the interest is keeping you from achieving your financial goals. You need to get rid of your debt to start saving for retirement, have extra money for vacations, and save for larger goals like retiring early or buying a house.
Your emergency fund can’t be ignored either. If you don’t save for emergencies, then you’ll accumulate the debt you had just paid off or end up in more debt than you started with.
Where to Keep Your Emergency Savings
Do not, I repeat do not invest your emergency fund. The last thing you want is to need the money when the stock market tanks. I like to use a high yield online savings account. This gives you a higher interest rate than a regular savings account which is awesome because it’s free money. It is also insured by the FDIC so you can’t lose your money.
What is also good about these accounts is that you can’t immediately touch the money. You have to put in a transfer or a wire to move the funds. Because there is an additional step you have to make to use your money, you don’t spend it easily.
I hope this gave you some insight into the world of emergency funds and how to use them to avoid getting into debt (or increasing your debt).
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