At some point in time you are going to need some cash to pay for those thing life throws at you. It has a funny way of kicking you when you're down. And when I say funny I mean Not Funny!
So we need to add some padding so when life does kick us it doesn't hurt so much. What's that padding? Emergency Savings.
Emergency savings typically means three to six months of living expenses in the bank if your employed full-time. If you are self-employed, freelance, consultant, etc, then you should really have nine months to a year saved up. I prefer online savings accounts but we'll get to that in a second.
Sometimes when we are starting out we have little to no savings. If you already have a $1,000 or more then you can skip to the next step. Congratulations!
For the rest of us, saving three to six months (or more) of expenses when you have nothing is quite daunting. So forget about that for now and concentrate on saving just $1,000.
Having $1,000 in the bank will cover probably 80% of the emergencies that get thrown at you. You know, that car repair bill or the unexpected medical emergency.
Now I already hear your excuses, I can't afford to save $1,000 this month, I'm living paycheck to paycheck, etc. And that exactly what they are excuses. You don't have to put it all in savings today. Do a little bit every month and it will start to add up. If you are serious about becoming financially secure, independent, or free., then you have to start some where and this is it. Start Saving!
I've got a little secret for you on the quickest way to get your initial emergency savings a huge head start. Want to know?
For most people that is enough to have one month+ of expenses in savings. If you do that, not only will you have this step done you'll be well on your way through the next.
But don't wait until tax time to start saving set it up now and start saving as much as you can, $50 per month, $100 per month. Even if it's only $10 a month you will be much better off than waiting.
This also works for Bonuses too.
Remember I said I would get to online savings accounts? Well, here it is. Where do we keep this emergency money? We need to keep it some where safe and easy to get to when we need it. Now we are not going to be able to make a lot of interest on money we keep in a safe place but that's alright. That's Not what this cash is for. But we might as well make as much interest as we can and that is usually in an online bank savings account, like Ally. Which is what I use for my emergency cash. Some credit unions have some higher rate savings accounts which is great. Just make sure you are using a savings account.
Now that you have $1,000+ in the bank what's next?
Well, there is a bit of debate about this. You may agree or disagree with me but this is how I did it.
If you have no debt, other than your house payment, just continue saving every month until you reach your goal.
Now if you are like me when I started, you have debt. In that case, continue saving a little bit every month, $10, $20, or $50. And use the rest to start paying down your debts, credit cards, auto loan, personal loans.
I used the avalanche method, a twist on the snowball method of debt reduction. You can read it my other post here.
Remember to continue to use your bonuses, pay raises, and tax refunds to accelerate your debt repayment.
Once you have paid off your debt use all that money to finish your emergency savings fund. The other great thing about paying off your debt is that as you lower your monthly expenses, i.e. your loan payments, you lower the amount you need in emergency savings. As I will show you in the example below.
Now that you have three to six months of savings, or more if you're self-employed, celebrate (a little). Go out for a nice dinner, or out to the movies.
I've tried to avoid using examples because the numbers can look quite discouraging. Please don't let that happen.
I'm completely making these numbers up for ease of the math. You should use our spreadsheets to calculate your actual numbers.
Lets suppose we are working full-time and our current monthly expenses are $3,000 with $1,000 of it is debt repayments like auto loans and credit cards.
Monthly Expenses X 3 months to Monthly Expenses x 6 months
$3,000 x 3 = $9,000
$3,000 X 6 = $18,000
Therefore, our emergency savings should be $9,000 to $18,000 (see I told you).
So we start out by saving our $1,000 which will leave us $8,000 to $17,000. We continue adding a small amount to it while we are repaying our debts. We will ignore that for now, it's mainly used to build the habit of savings.
Now suppose after 12 months we have paid off some of our debts and will only need $2,500 a month to pay our expenses. The effects are quite impressive.
$2,500 x 3 = $7,500
$2,500 x 6 = $15,000
That only leaves us $6,500 to $14,000 left. Cool. But what happens when we finish pay off our debts. Then we need a total savings of $6,000 to $12,000.
Going back to our original three months of savings we needed $9,000 with saving $100 a month it would have taken us 7.5 years to save up that amount. But once we lowered our expenses we would on need 5 years of savings. However, if you are like most us and getting $3,000 refund a year you could your emergency savings in less than three years.
And it's not under the mattress!
For those of you who are a bit further along your financial independence journey and can tolerate a bit more risk. We can make our emergency savings work a little hard for us. If you are just starting out in your journey to financial independence you should start with all your savings in a bank savings account, preferably an online bank. As you move further along your path you can begin to take a little more risk.