Becoming Financially Resilient
Prepare for the unknown
To be resilient is to be able to recover quickly from a difficult condition. Difficult conditions will happen. It’s not a matter of “if” but “when”. While we may not be able to prevent all difficult conditions from happening, we can develop resiliency to recover from them. The difficult conditions we are speaking of can include loss of income, or an unexpected expense.
In personal finance, resiliency is provided by a short-term emergency fund and longer-term reserve funds. In this post, we will focus on what the emergency fund is, how it can help you face the unexpected, and qualify when it should and should not be used.
How important is the emergency fund?
Let’s imagine you are driving down the road and your car suddenly breaks down. Your plans for the rest of the day are disrupted. Financially speaking, is this a crisis or is it an inconvenience? According to the Federal Reserve, 68% of all adults do not have the cash to cover a $400 unexpected expense. If this is you, then this is likely a crisis. If you have a well-funded emergency fund, this is just an inconvenience.
The emergency fund is so important that Dave Ramsey’s 7 baby steps start off with building an emergency fund of $1,000. Whether you love Ramsey or not, he is well known as an anti-debt crusader. He states that all debt is bad debt and that everyone should do anything they can to get out of debt. Yet the first step of his plan is not to pay down debt, but to save up $1,000 to begin an emergency fund. Yeah, an emergency fund is that important!
Save up at least $1,000 to start your emergency fund and you are no longer in the 68% camp reported by the Federal Reserve.
Math vs. Psychology
Finance is a quantitative discipline. Decisions are based on “return on investment”. Everything can be calculated to a yes/no decision based on numbers. Add “personal” to it and that changes things. Personal finance uses all of the same mathematical formulas, but when it comes to the emergency fund, we seek safety over returns. Your emergency fund should be accessible and stable. This means that it should be in a money market account or a high-yield savings account. It’s the insurance policy for the bumps in the road.
What could possibly go wrong?
We are always told to “look at the bright side”, but taking some time to consider our risks and making our resiliency plan is important. Think about what could go wrong. What would happen if you lost your job, or were hospitalized, or something happened to your home? Having a solid understanding of your budget and looking at things like your insurance policies will help you model potential events and plan how you will meet them.
For example, if you have 3 to 6 months of expenses saved then a job loss is much less stressful than if you were living paycheck to paycheck.
If you are struggling with debt, you can follow the 7 baby steps which prioritizes paying down the high interest debt after saving $1,000, then building up your emergency fund further for 3 to 6 months of expenses.
To spend or not to spend?
Your emergency fund is your insurance policy for unexpected expenses, but when is it okay to use it and when should you not use it? To answer this, let’s qualify an emergency. An emergency is any event that cannot be reasonably anticipated and demands attention.
For example, you notice that you have a nail in one of your tires. If you do not have it fixed, your tire could run flat, or worse you could suffer a blow-out on the highway. This is not reasonably anticipated, but it demands attention. It is something that if you do not resolve it, the consequences could be much worse.
When should you not use the emergency fund? Do not use it for anything that is not an emergency! A sale at your favorite clothing store no matter how good, is not an emergency. Wanting a pizza is not an emergency. Only use your emergency fund for things that are legitimate emergencies.
Give yourself permission to use your emergency fund when needed. For example, if you are experiencing a tooth ache, this could be a sign of something that could get much worse if left untreated. Do not put off something that needs to be addressed just to hold on to your emergency fund!
For example let’s say you are cooking and a fire breaks out on your stove. You try a few steps to put it out and nothing works, but you have a fire extinguisher nearby. You know that if you use it, the small, but growing fire will be put out, but the extinguisher would be consumed. Do you let the fire grow and hold on to your extinguisher? Of course not! You would immediately put out the fire to prevent tragedy.
Once the crisis is averted, you would replace your extinguisher, and that is what you would do with your emergency fund.
Planning reduces emergencies
In the beginning, I stated how emergencies were unavoidable and now we talk about reducing them by planning, but how can this be?
Introducing the reserve fund. This comes after the emergency fund and it covers expenses that demand attention but can be reasonably anticipated.
For example, when it comes time to change the oil in your car, that can be reasonably anticipated. That’s not an emergency, it is a regular maintenance item that we can plan for. Reserve funds can be used for all sorts of expenses ranging from your semi-annual auto insurance premium payments to planning to replace the roof on your house.
Learn more about simplifying your financial life and planning for expenses here:
Conclusion
The emergency fund is perhaps the most important and first-step to financial independence. Having a well funded emergency fund enables us to become more resilient financially and will help us handle the inevitable “bumps in the road”