How to Create (and Grow) an Emergency Fund in 3 Solid Steps
I learned a BIG lesson in 2020.
It was January and I was sitting in my usual seat at the back of the air-conditioned lecture theatre.
My classmates and I were spread out in the room; there were about 35 of us in a room that could seat roughly 100 people.
So, I was enjoying the comfort and listening to my lecturer discuss financial preliminaries.
The course was called Investment Analysis and Portfolio Management and there were two key takeaways from this introductory lesson.
The first was that there are different stages in the investment cycle - accumulation, consolidation, and spending.
But, the information that really stood out to me was the financial preliminaries necessary before investing.
I could picture all the mistakes I made while attempting to build an investment portfolio. And one of the biggest mistakes was investing without a solid foundation of financial preliminaries.
What Financial Preliminaries are Necessary Before Investing?
You should have these three things before you invest:
A Rainy Day Fund/Emergency Fund
Health Insurance
General Insurance (Life or property)
This article focuses on everything you need to know about an emergency fund.
What is an Emergency Fund?
An emergency fund is essentially backup money, somewhat like exaggerated savings. The word “emergency” suggests urgency and something happening unexpectedly. Your emergency fund helps you financially deal with the unexpected nature of life.
I hate bringing this up because it seems like an over discussed topic. But, the coronavirus pandemic is the most unexpected event to happen in our lifetimes. It taught us many lessons, chief of which was the realization that jobs are ephemeral.
About 25% of adults in the United States (U.S.) lost their jobs because of the pandemic. Those who didn’t have a solid emergency fund found themselves in debt, had trouble paying bills, or got food from a food bank.
A strong emergency fund has at least three to six times your current salary. It can surely seem difficult to put aside three to six times your salary and just have it sit there, waiting for the unexpected. But, you must develop the discipline to make your emergency fund possible so that your investments have a chance to grow.
What is the Difference Between an Emergency Fund and a Rainy Day Fund?
A rainy day fund is based on a premise similar to that of an emergency fund. That’s why people often confuse them. Here’s the difference - a rainy day fund is much smaller than an emergency fund and is used to cover smaller, expected expenses.
I can give you an example from firsthand experience. A man saw my car parked in a vacant lot in late December 2020. He said, “How have you been driving with those tires? They must be changed. If you don’t change them, you’re either going to have an accident or get a ticket from the police.”
He then showed me what was wrong with three of my tires. If you own a car you know how expensive tires can be (depending on the make and model of your car), especially if you want the best quality tires. Now, this man was telling me I had to change three tires.
Thankfully, I had a rainy day fund. So, I could easily spend the 27,300 JMD (approximately 190 USD) required to change the three tires. That’s what a rainy day fund does - it helps you cover the expected (yet unexpected) expenses.
I knew my tires would need to be changed eventually...every car owner should know that. But, I just didn’t know when they would need to be changed. I also certainly didn’t expect to change three simultaneously! Yay for the rainy day fund!
The table below shows expenses that would be covered by a rainy day fund versus an emergency fund.
Rainy Day Fund vs. Emergency Fund
| Rainy Day Fund | Emergency Fund |
|---|---|
| Minor home repairs | Expenses resulting from an unexpected job loss |
| Your child’s braces | Expenses resulting from an economy in recession |
| Minor car repairs | Unexpected medical expenses |
Rainy Day Fund vs. Emergency Fund
Rainy Day Fund Emergency Fund Minor home repairs Expenses resulting from an unexpected job loss Your child’s braces Expenses resulting from an economy in recession Minor car repairs Unexpected medical expenses
Here’s how I like to think about it.
Emergency Fund = Big Expenses
Rainy Day Fund = Small Expenses
How Much Should I Have in My Emergency Fund?
An emergency fund (at its most basic level) should be at least three to six times your current net salary. You won’t hit this goal immediately; it’s something you have to work on over time based on your overall financial goals. Here’s a table with a general breakdown of emergency funds for various monthly salaries.
| Net Salary (in USD) | 3 Times (in USD) | 6 Times (in USD) |
|---|---|---|
| $500 | $1500 | $3000 |
| $1000 | $3000 | $6000 |
| $1500 | $4500 | $9000 |
| $2000 | $6000 | $12000 |
| $2500 | $7500 | $15000 |
| $3000 | $9000 | $18000 |
| $3500 | $10500 | $21000 |
| $4000 | $12000 | $24000 |
| $4500 | $13500 | $27000 |
| $5000 | $15000 | $30000 |
| $5500 | $16500 | $33000 |
| $6000 | $18000 | $36000 |
There are two questions that you should ask yourself as you consider your emergency fund goal.
Which works better for my financial needs - three or six times my current income?
Will I need more than three to six times my current salary to last me for three to six months?
Here’s a list of possible expenses/investments you should consider when answering these questions. Pay attention to those that apply to your current situation.
Utilities
Loan repayments (mortgage, car loan, personal loan)
Health insurance payments
Life insurance payments
Retirement fund
Groceries
Childcare
School fees
Car maintenance
Car insurance
Rent
Homeowners association fees
Home maintenance
These are the steps you should follow to determine the best multiple (3x,4x,5x, 6x …) to use for your emergency fund.
Write the average dollar value for each of your expenses.
Sum the figures and break them down to a month-by-month amount. This is your break even point.
Determine whether you want a three-month or six-month emergency fund.
Multiply your current salary by each multiple (starting with 3x) to determine if you’ll hit your breakeven point and still have a profit if your income dries up for three (or six)months.
The multiple that helps you achieve the objective outlined in step three is the multiple you should use.
Here’s an example for a three month emergency fund.
Average Expenses = $2,000 per month
Current Salary = $3,000
3x Current Salary = $9,000 Average Expenses for 3 months = $2,000 * 3 = $6,000
Profit = $3,000 (This represents 50% profit.)
Should My Small Business Have an Emergency Fund?
A thousand times yes! All businesses need emergency funds to prepare for the unexpected.
One of the biggest mistakes micro and small business owners make is not separating their business income in a way that makes an emergency fund possible. I’ve been guilty of this, so here are three things I’ve learned to avoid this trap.
Pay Yourself
I’m a freelance writer. So, it’s easy for me to automatically take all of my net income for my personal finance goals. But, this strategy can’t work if I want to grow my business.
The best solution is for me to pay myself from my net income. It’s a difficult task because my income fluctuates. But, it’s necessary if I want to achieve sustainable success.
Paying myself a percentage of my net income gives me the wiggle room to set aside money for my business’ emergency fund. I’m learning to pay myself 70% of my net income, invest 10% back into the business, and put 20% into an emergency fund. I discuss how I manage that 70% I pay myself to create a personal emergency fund later in this article.
Have a Budget
An emergency fund should be a line item in your business’ budget. The beauty of budgeting is that it helps you create a financial plan for the quarter or year. You have a budget for your personal finances. It’s even more important for you to have a budget for your business.
Spend Within Your Means
Your business won’t grow if you don’t reinvest your profits. It would be great if I could reinvest all my profit for business growth. But, I still need to survive so some of that profit is my personal income.
What’s most important is understanding how to reinvest the profit in ways that won’t force you to overextend your finances. Reinvest in growth opportunities that fit within your budget. Otherwise, you’ll either grow too quickly (which leads to more financial problems) or find your money washing away like a roaring river with nothing to show for it.
3 Solid Steps for Creating (and Growing) Your Emergency Fund
Creating and growing an emergency fund takes strong commitment and an unwavering resolve to see your goals come to fruition. Here are four solid steps to make it happen.
Have a Clear End Goal
An emergency fund is the result of clear financial goal-setting. It’s more than saying, “I want to earn a six figure salary by the end of the year.” Financial goal setting with an emergency fund in mind follows two steps.
Step #1 - Identify Where You Are Now
Realistic financial goal setting begins with understanding where you are now financially. Grab a sheet of paper and write:
Your total net income from all income sources
Your expenses (list all expenses and then sum them)
The current size of your investment portfolio
The amount of money in your personal savings
Don’t be anxious if you don’t have anything to write for points three and four. You’ll get there.
Laying out these figures helps you get a clear sense of where you are now. Answer these questions:
Are my expenses too high? What expense do I need to get rid of so that I can have more available cash?
Is my total net income at least twice my expenses?
Have I been saving enough?
What’s the term to maturity on my investment portfolio and how much money should I have at the end?
Step #2 : Be Realistic
An emergency fund is created within the parameters of your existing financial condition. It’s then adjusted as your situation improves.
Think carefully about where you are now and where your emergency fund needs to be. What does your emergency fund figure look like? How long will it take you to achieve that goal?
Let’s say you should have $15,000 in your emergency fund but you’re only earning $700 monthly after all expenses and taxes are deducted. Let’s say you save $200 out of that $700 for your emergency fund. It would take you 75 months (6 ¼ years) to achieve that goal! That doesn’t sound so realistic right?
You could do one of three things. The first is to reduce your expenses significantly so that you can save more money. The second is to look back at the multiple you’re using and adjust it so that it’s more realistic. The third is to work on other income streams.
Stick to the Plan
Let’s say you need to save $250 per month so that you can hit your emergency fund goal of $6,000 in two years. It’s really hard to put aside that much money when there are so many other things that you need to do. But, you have to stick to the plan.
I don’t know if you experience this, but I often get to a stage in my emergency fund savings where I feel like I have so much money stashed away that it’s okay for me to dip into it for small emergencies. Dipping leads to crashing. It’s the quickest way for my emergency fund to move from something to nothing.
Don’t dip into your emergency fund! It’ll look like a shiny treasure that you need to use. But, it isn’t. You could even set up your emergency fund account in a way that there’s a penalty if you withdraw funds before the maturity date. That’ll keep you in check!
Create Multiple Income Streams
The best way for an emergency fund to grow quickly is to put more money into it. That’s why you need multiple income streams. A nonfiction book is an income stream option that you could consider.
You can outsource the book writing process and then reap the rewards when copies start selling. Learn more about creating a nonfiction book by clicking here.
Final Words
Life is unpredictable. You need an emergency fund to help cushion the blow of major financial stresses. But, quickly creating and growing an emergency fund requires multiple consistent income streams, a clear goal, and the willpower to stick to the plan.
Need help figuring out what you should do to create and grow your emergency fund? Schedule a 15-minute consultation with me.