This is Why You Need a Rainy-Day Emergency Fund

by RedBeard

Its widely accepted that having an emergency cash fund is essential when an unplanned event pop up. But how much do you need to save? And what’s more important – saving for a rainy down or paying down debt?

Based on studies from the Federal Reserve and analysis by JPMorgan Chase, I recommend that if you are struggling with debt, then first save $1000 to $2000 while making the minimum payment. Once you have that, begin to increase the debt reduction plans.

None of us know what is around the corner. 2020 certainly showed us that. An emergency fund can help to soften the unexpected expenses that will happen. Just to be clear, the cash in the fund is not to buy the latest phone or shiny new shoes. It is there for the tribulations of a medical emergency, or job loss or if your oven breaks.

What’s more Important, Debt or Emergency Fund?

The truth is that they are both important. If you have just a small gap between income and expenses including debt repayments, then dealing with an emergency is very difficult. But at the same time, the debt repayments are keeping your poor.

What the Data Shows

The Federal Reserve of Saint Louis conducted a study to see which is more important, paying debt or having an emergency fund. The study concluded that it is better to have cash on hand for an emergency than to pay down high interest debt.

The Urban Institute, a US based non-profit organisation, conducted an extensive study to assess the impact of an involuntary job loss, a health-related work limitation, or an income drop of 50 percent or more. Their study concluded:

  • Families with even a small amount of nonretirement savings are less likely to be evicted, miss a housing or utility payment, or receive public benefits when income disruptions occur. The savings cushion kicks in with very low savings levels ($250–$749); for public benefits, any savings reduce benefit receipt. Higher savings levels, however, are associated with even lower hardship levels and benefit receipt. These relationships hold when taking account of family incomes.
  • Low-income families with savings are more financially resilient than middle-income families without savings. 

How Much to Save?

A JPMorgan Chase research report suggested that a middle-income family needs about $5,000 while lower-income families need about $2,500 in their rainy-day fund. This is to deal with a spike in expenses. The report suggested that a family should have 6 to 7 weeks of income to “weather a simultaneous income dip and expenditure spike”.

That guidance is general and is based upon assumptions. Based on all the research that I have read, I would give more specific recommendation depending on your circumstances.

  • Situation 1: Your income exceeds the normal monthly expenses, start to save $1000-$2000 as the first instalment of the emergency fund. During this time, make minimum payments on your debts. Do not take more consumer debt. Once you have saved the fund, paydown the debt and move to situation two.
  • Situation 2: Again, it is assumed that your income exceeds normal monthly expenses. This time, you do not and will not have consumer debt, then begin to save to 6 weeks, and follow on to several months of income.

Hopefully are following our philosophy and have a plan to not only reduce your debt, but also to increase your income.

Where do I get the Money to Save?

Review Your Budget to Cut Expenses

List all your monthly income and expenses. Review your spending habits above just your standard expenses. If you don’t know where your money goes, (its surprisingly common) then track where you spend it. You Can download a free tracker from Consumer Financial Protection Bureau. Make a budget to ensure you cover the essential, cut the “luxuries” and see how much money you have available to put toward your savings.

Sell Old Items

My wife’s sells something every month. Most months she sells a couple of things. Generally, it can raise between $20 and $80. It may not seem like much, but it adds up and can really count when times are tough.

Start a Side Hustle or Get a Second Job

Taking a second job or starting a side hustle is not easy. But if you have a specific goal to motivate you, it will be easier. Maybe your goal is simply to save $2000. So, you take a second job for 2 months until the money is saved. Most likely you can repeat this part time working until you get to $5000.

If you’re not sure what idea to follow, read our post Here’s What Makes a Great Online Side Hustle, get some ides from 9 Simple Side Jobs for Extra Cash, or have a look at all our articles related to side hustles and second jobs.

What is the best way to save?

Have a Goal

Decide how much you want to set aside each month to build up your emergency fund. Like all budget decisions, this should be done in consultation with your spouse, partner or whomever. Stick to the budget to make the goal a reality. Once you have achieved your goal, have a small celebration.

Automate

I get paid on the same day each month. The following day my bank automatically transfer money into different bank accounts. This helps us to manage our budget and ensure that we always put money into our saving.
You can do the same. Arrange for money to be automatically transferred to a savings account either directly from your pay-check (by your employer) or by your financial institution once your pay-check is deposited into your account. There is no decision or remembering to be made. The saving just happens.

Save extra when times are good

The JPMorgan Chase research mentioned above, suggested some families may be more likely to continue to save and achieve the goals over a longer term, if they save aggressively when they have a spike in their income.
I can give an example here as this is something that I do. Every year I expected to receive a tax refund and a bonus from my day job. I save 100% of the tax refund and 90% of the bonus. This allows me to reduce the amount saved each month. Should I get unexpected money, I also add this to the saving account.

How do You know if You Can Use the Money

Its a valid question. If you have made all that effort to save the money, you may be hesitant to use it have to go through all that again. Here are couple of questions to ask yourself:

  1. Can You pay for out of my normal monthly expenses?
    • If the expense is small, can you deal with it from of your monthly income? Perhaps that means you will have to skip somethings that is not essential.
  2. Is it unexpected?
    • In reality, we know about and can plan for most bills – rent, insurance, tax, etc. If you have a budget for these, then you don’t need to use the emergency fund.
    • But, damge to your home or car, a medical emergency, sudden drop in income can’t be planned. So, if you cannot cover the expense from your normal monthly income, then use the fund.
  3. Is it absolutely necessary?
    • There are many unplanned even
    • A small crack in our phone screen can wait, or is not necessary to fix at all.
  4. Does it Have to be Now?
    • Can you delay or spread the payment for several months to allow you to plan and adjust your budget to compensate? This would allow you not to use the emergency fund.
    • Things like a dentist or doctor visits obviously need to be done immediately.

Conclusion & Actions

  1. Set a goal to save $1000-2000 as a priority. Make the minimum necessary payment on debts
  2. Review your budget to see where you reduce expenses. Use money from reducing debt repayments (if possible)
  3. Once you have saved the 1k-2k, aggressively repay the debts.
  4. Once the debts are gone, gown that savings fund to 5k, and then to 6 months of expenses.

Have you saved your emergency fund? What do you think of the amounts we suggest and prioritising a personal emergency fund over debt? Maybe you’ve got your own ideas of what to do, feel free to share that too!

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