Creating an Emergency Fund

A lot of young people today start out their adult lives with a substantial amount of debt from student loans and credit cards.  When they land their first professional job, their immediate financial goals focus on paying off this debt while still paying their bills.  By creating a budget that puts everything towards paying off loans, however, they are neglecting to protect themselves against a catastrophic or even minor event that can add more to their debt.

As a financial counselor, I often repeat the advice to my clients to save at least eight months of their living expenses in case of an emergency such as a job loss.  While many older people usually have money set aside somewhere, many of the young people I see have just started out on their own and don’t have anything saved.  In addition, when reviewing their budgets, many of them simply cannot free up more than 10% of their net salary to put towards any kind of savings account thanks to early financial mistakes or student loans.  When you consider that this means about 90% of their net income goes towards their living expenses; creating an eight month emergency fund means putting aside 60% of their annual salary.  If they can save 10% of their salary a month, it would take them six years to amass that amount of money, assuming nothing happened in that amount of time to cause them to pull money out.

For my younger clients, I recommend that they build an emergency fund by following a series of small, attainable goals.  Following these steps allows my clients to work towards financial stability while still making progress on their loan obligations.  In addition, each goal gives them a feeling of better security since they are able to see which types of emergencies they are prepared to handle, and which ones they aren’t protected against.

Save $100 in your checking account.  I advise many people who have had difficulties with bouncing checks or debit card charges that went through despite of there being insufficient funds in their accounts.  Often, these charges are for amounts less than $10, but the accompanying overdraft charges can be higher than $25.  Putting $100 into their checking account, then subtracting the amount from their check ledger as “emergency fund”  or “overdraft protection” takes care of these overages without having to pay the overdraft fees.  Of course, this only works if clients keep check ledgers.

Saving this amount isn’t significant at all to some people (many of my clients tall me they’ll just skip a Friday night at the bar), but to others this is the first time they’ve had to save anything.  Furthermore, clients who have trouble with this goal are used to spending everything in their checking account (oftentimes by checking their bank balance before shopping).  Changing that behavior is the hardest part of this step for them, and in a lot of ways is more significant than the actual amount saved.

Save your insurance deductibles in a savings account.  The reason insurance premiums are so high for the under 25 age bracket is their propensity to get into accidents.  Even a minor fender bender can result in a claim on their insurance.  Typically, many young people have increased the deductible on their policies in order to save money on the premiums.  Unfortunately, this leaves many of them vulnerable to putting that deductible on a credit card when an accident does happen.

Typically, meeting this goal involves saving about $1000.  Of course, for some clients it also involves getting renter’s insurance in the first place.  The major roadblocks to meeting this goal are usually smaller emergencies (such as car repairs or emergency trips out of town) or a client using the money he or she has saved to make a large purchase.  In the case of smaller emergencies, remember that an emergency fund is supposed to prevent one from increasing his or her consumer debt obligations.  As long as they continue to save, they’ll get there.  For clients who they just can’t see that much money sitting in an account without shopping, suggest they place the money in a savings account with a different bank than the one they do their primary banking with.  This will slow down the urge to take the money out without really thinking through the purchase first.

After this amount is sitting in a savings account, take a break.  Actually, just start putting money towards paying off your credit card debt.  With this small amount in savings, most young people can cover a lot of the small emergencies that come up in their lives.  Knowing that they’re covered against having to use a payday loan service or high interest credit cards, it’s time to eliminate those types of debt from their budget.  For clients who have the option, I also recommend contributing enough to their retirement funds to get the employer match at this point.  Once a client has eliminated the credit card debt and started some long-term planning, move on to the next step.

Save the amount to replace a car.  Please note that I don’t ask them to save enough to replace their car, just enough to buy a reliable vehicle that can get them to and from work.  In most areas of the United States, this should cost around $5000 (there are cars sold for cheaper, but they’re hard to find and often need maintenance).  Being able to replace a car give one the ability to drop comprehensive insurance on an older, paid-off vehicle.  This amount will also cover the vast majority of minor and mid-range home repairs, allowing clients to take the next step.

Save 25% of the purchase price of a house.  If a person or family is renting, this will become their down payment.  Using the equity in a home is not a great way to fund a situation such as a job loss, but buying a home allows a young family to contribute regularly to an appreciating asset instead of paying rent.  Knowing that the money is going towards something tangible is usually a great motivation for people to save, as well.  

After they’ve bought, they will have about 5% of the value of their home as an emergency fund, and the ability to draw down a home-equity loan if they need more.  I recommend that no one actually buys a home unless the purchase (including closing costs and moving expenses) will leave them with enough money in their emergency fund to cover the previous step.  Since this will deplete their emergency fund quite a bit, I tell clients who have recently bought to repeat this step; in other words, put aside 20% of their home’s value (this gets added to what they have leftover from their “old” emergency fund).

After doing this, a client should ideally have no credit card debt, a good start on their retirement accounts, and a house with at least 20% equity.  The difference between eight months of living expenses  and the amount they have in their emergency fund can be saved relatively quickly.  In some areas of the country, having 20% of their home’s value in savings will cover over a year of living expenses (in other places it will only be a few months).

I also like to remind clients that this will take years to accomplish, and there will be setbacks along the way.  Just remember to be grateful you had something put aside, and start again.  It will get easier.