The Getting Started Series Part 1: Emergency Fund

Getting Started Series Part 1

This is a series intended to answer the question “I’m covering my bills, now what?” It’s for people who have a steady source of income and have a vague notion that they should be doing something more with their money, but don’t really know how to begin. This will go through what to do with that money post-bills, from setting up an emergency fund, to debt management, retirement, and investment. Although most of this information is applicable to civilians, we’ll also be providing resources and information specifically geared toward military servicemembers and their families.

I’m going to begin with the assumption that you have a steady source of income and you are covering your bills. Now what? Your first step is to start an emergency fund.

What is an emergency fund?

This is aptly named because it is money set aside for an emergency. It could be anything from a medical emergency to car problems to a house flood.  An emergency fund is also intended to help you cover your bills should you lose your job.

How much should you keep in your emergency fund?

Most experts recommend having six months’ worth of bills saved in your emergency fund, which you should keep in a savings account for easy access. So the first thing you need to do is add up all of your bills. This includes car payments, student loans, electricity bill, your average credit card bill, the rent or mortgage, cell phone bills, and anything else you pay. Being conservative is the key to an emergency fund, so I would err on the side of too much rather than too little. You could also use the calculator here to aid you in calculating the amount needed for your emergency fund.

However, aside from cold hard numbers, you also need to take into account your own circumstances. I heard on an episode of MoneyTrack that if you are making over $80,000 a year, you should actually save twelve months’ worth of bills since it’ll be harder for you to find another job that pays so high. I would also recommend saving more if you have a job with low security or if there is talk of lay-offs.  If you are a military family and expect to PCS in the near future, you should also build up that emergency fund as it may take a while for your spouse to find a new job. The opposite is true of course as well. I am a tenured teacher and I teach bilingual education, so I’m a difficult person to replace. Davin is a military physician and owes 10 more years to the military, so it is highly unlikely that he would be let go even if the Air Force started cutting jobs again. Additionally, as he is in residency, we are guaranteed three more years at our current station. Therefore we feel comfortable at the recommended six month baseline, but you may want to consider saving more.

On the flip side, save too much and you’ll end up losing. Finding that sweet spot for your emergency fund will depend on your own personal situation, but when you start to hold on to more than 6-12 months’ worth of income, then you have money that isn’t working for you. Even worse, you will instead watch as your hard earned money starts to lose its buying power by approximately 3% annually due to inflation. Saving cash in a savings or checking account is perfectly okay if you have specific short-term goals outlined. For example, if you are saving for a down payment on a house, or you are saving up to make a big purchase such as a car or even a vacation. However, if you are not planning for such a purchase, you should be finding ways to make your money work for you. Later in this series we will outline how to invest that extra savings.

Why is an emergency fund first priority?

emergency photo

The emergency fund should be your first priority, even over paying down debt. This is because the emergency fund is your buffer from going into debt. Let’s say for example that you have $5,500 in the bank and decide to pay off your $5,000 car loan that you were paying 6% interest on and you now have $500 left in savings. I’m sure paying off your car and not having that monthly payment was a big relief.

But then you get a phone call that granny is in poor health and is not expected to pull through. So you buy a last minute plane ticket to say good-bye. Your travel expenses come out to $1,500. You only have $500 in savings, so you charge the remaining $1,000 to a credit card with a 19% interest rate. Now you’re back in debt again at a higher interest rate and your savings account is completely wiped out. Looking at this a little closer, you realize that the car loan of $5,000 would only have accrued $300 worth of interest had you not paid anything on it at all. While you may have enough time to pay off the $1000 credit card bill, if you don’t, or if your next paycheck will go towards monthly bills, just remember that 19% can add up quickly, and in this specific case would cost you an additional $190. And that credit card payment will only continue to rise unless you are able to pay it in full.

Right about now I can imagine many readers are saying, but isn’t $190 less than $300? Yes it is. The difficult part to remember is that in this scenario, we have $5,500 cash in the bank, plus a car loan of $5,000 which has a 6% interest rate. Put all your cash towards this bill and you won’t have to worry about it in the future, but it doesn’t leave any wiggle room for expenses that might pop up. When you extend yourself by making new payments on to a credit card at a much higher interest rate it’s easy to see how much more you could end up paying when we change the figures ever so slightly – so let’s do just that.

Imagine that with your $5000 you pay $2500 of the car payment, leaving $2500 left of the loan at 6%, which comes out to a $150 monthly payment remaining on the loan. Now if you are unexpectedly faced with purchasing the last minute $1500 plane ticket, you can without putting it on your credit card (unless you do so to earn rewards, which is an entirely different subject we will cover later), like in the first scenario. Already you’ve saved $40 compared to the scenario where we accrued $190 in credit card interest. What if you paid an extra $1000 on the car? This means you’ve paid $3500 towards it, leaving a balance of $1500 at %6, which is now $90.

What if the cost of the unexpected plane ticket is more expensive and you spent all your loose money on the car payment? For example, let’s say the plane ticket costs $2500 and it has to go on the credit card at 19%. Now the cost of interest adds up to $475. These varying scenarios help to realize that sometimes it is better to carry balances on big ticket items that carry lower interest rates in order to maintain that emergency fund for when unexpected expenses arise in order to stay away from incurring heavier interest rates from a credit card.

Let’s not get too bogged down in the details of good versus bad debt for now (we will cover that more in our next edition – Part 2 Debt). The take away should be that you won’t always know what is going to happen next in life, therefore preparing for the storm helps when you pack an umbrella. In other words, save and hold on to a set amount of liquid money for those unexpected situations when they present themselves.

 

Check in next week for our continuation of the Getting Started Series- Part 2: Debt.

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