Lately there have been a number of great posts and strong opinions about having an emergency fund, and I wanted to weigh in with my own opinion and experiences. I have had a long a standing love-hate relationship with emergency funds. Sure, you need them for critical situations! But my problem (and I think this is where a lot of people struggle) is how to save up enough. Depending on which advice you subscribe to, the recommendations can be anything from 3 to 12 months of your gross monthly income. If you’re a typical American household making $60,000 per year, that’s anywhere from $15,000 to $60,000 that we need to have in the bank! Ouch! Is it any wonder we fail at this?
The other problem is that once you do get on a roll and make your way towards that initial $15,000 emergency fun, your mind starts getting awfully creative. You start to think to yourself: What if I paid down some debt? What if I put it towards my Roth IRA? What if I invested it in something totally different? And then we’re right back where we started…
The Alternative Emergency Fund Strategy – Step 1:
Consider that the average monthly budget probably looks like this:
Let’s totally forget about our emergency fund situation for a minute and focus only on our budget. What if over the next few years, you were able to work towards some type of ideal budget similar to this:
That would be pretty great! But what in the world does focusing on my budget got to do with my Emergency Fund? The answer is more than you think!
1) By budgeting your money properly and diverting it to various savings goals, you’ll have more “streams” to grab from when you’re in trouble. What I’m calling streams are any of the important things you voluntarily put your money towards like your 401k, Roth IRA or any fixed rate savings account, etc.
2) You’ll learn to live with far less expenses. It’s a lot easy to cover your expenses when they’re 40% of your income versus 70%. In other words, you’ll need less money when you’re in trouble.
The Alternative Emergency Fund Strategy – Step 2:
You weren’t getting out of saving up for an actual emergency fund – you know that right? Should your finances ever hit DEFCON 1, you’re going to need some cushion to survive on.
The good news is that now that our budget is in order and we’re living off of less money, you’ll need to save less money. Think about it – if you lost your job, the only important thing you need to cover are your expenses (your savings and goals will simply have to wait). And again, it’s a lot easier to cover 40% versus 70% of your income. So if we base our emergency fund target on expenses only, that $15,000 to $60,000 goal can now be cut down to a “Reduced Emergency Fund” of $6,000 to $24,000.
Emergency Fund Scenarios:
Consider how this strategy would help you:
Emergency Fund Scenario 1 – Times Are A Little Tight:
No problem. Just borrow from that Reduced Emergency Fund. If that doesn’t cut it, you also have the option to divert one of your lesser priority streams such as the “Extra Debt Payments” or “Extra Savings” towards covering the expense. Of course focus on getting back on track as soon as possible so you can go back to your normal budget soon.
Emergency Fund Scenario 2 – Things Are Really Rough:
Uh, no! My car died and I need a new car NOW! Or my roof is leaking and I need a new one NOW! Again, use the tactics in Scenario 1. If that doesn’t cut it, then you may have to dig deep and raid some of your higher priority streams such as the “College Savings”, “Roth IRA”, and “401K”. Of course try reducing them rather than cutting them down completely. And get back on track as soon as possible!
Emergency Fund Scenario 3 – The Lost Job:
This is possibly the worst scenario of them all because if you lose your job, you lose your primary (or only) source of income. This is why saving that Minimum Emergency Fund and striving to keep your expenses low helps. While you may not be able to save for retirement, you certainly won’t starve and you’ll be able to keep up with your main expenses. It will sting to let your savings goals sit idle, but use that pain to find a new job and get your life back on track!
Although I don’t endorse this, in the most extreme of extreme situations you can:
1) Withdraw the principal (not the earnings) from your Roth IRA after five years
2) Borrow against your 401k with intentions to repay it in the future
I would make that the absolute last possible resort option. Be cautioned that taking money out of your retirement account early is sabotage against the power of compound interest.
One last note: Notice I called Scenario 3 the worst because a job loss usually means losing 100% of your income. So why not diversify your income by creating alternative streams of passive income in addition to your job? Consider that if you had other forms of passive income coming in and suddenly lost your job, then your needs for the emergency fund would be even further reduced. Plus who doesn’t want MORE money?
Readers – What do you think of saving for an emergency fund? Do you have alternative strategies for dealing with extreme situations or possible job loss?
Photo Credits: Microsoft Clip Art, MMD