Start emergency fund — Walk before you run
If I asked you, how would you build a skyscraper? You would probably tell me: “Well, first, of course, you would have to build a strong and stable foundation. Only then you lay down the bricks and build it higher and higher.”
And you would be totally correct. The same goes for your financial house. Or your financial skyscraper. You would need to first build a foundation in which you can support yourself and fall back on when emergencies happen.
So if you don’t have an emergency fund, forget about paying big debts and investing first. Getting an emergency fund is the no. 1 step in your financial makeover.
Just for illustration, if you wake up tomorrow morning and realize you have to lose 10 pounds, build up muscles and completely change your diet, what would you do? You would force yourself to run 10 miles, hit the gym for 3 hours straight training every single muscle group, and follow the most extreme diet known to mankind. And you would collapse within the first few days.
The point is, as with doing any other things, we can’t try to do everything at once. If you try to spread out your $100 into returning credit card debt, investing, putting extras into retirement accounts and savings, your effort would be diluted.
And you won’t see any progress anytime soon. This is dangerous because if you feel like you have not accomplished anything, soon you will lose the will to keep going and give up on money management altogether. DO NOT give up on what you set out to do.
The power of focusing on one step at a time is what will make things work. Of course, there are things you can do to speed things up while following through the steps. Such as spending less or earning more, which both translates to more available savings.
What is Considered an Emergency?
An emergency is something you have no way to foresee, something that has a major impact on you and your family if you do not cover it. Emergencies include a job loss or cutback, medical bills from accident or unforeseen medical problems, or a repair cost you need to cover for you to function, such as your car.
Again, we have to exercise some self-control here. Something on sale that you “need” is not an emergency. Buying another car or going on an expensive vacation is not an emergency. These luxuries will come, of course, but not at this point of time. There will be time when you can buy a second car and pamper yourself with luxuries, but that will come at a later stage.
On the other hand, don’t make payments on medical bills after an accident while your emergency fund sits there fully funded. If you used a credit card to pay for the bills, make sure you pay back the amount with your emergency fund before the due date.
When you have gone through the trouble to create a dedicated emergency fund, make sure you know what is an emergency, and what is not. Before using the emergency fund, back up from the situation and calm down. Analyze if the situation is indeed an emergency and if you really need to pay for it.
Do not rationalize the use of your emergency fund for something you should save for and purchase.
How much should I have for emergency fund?
For starter, we would save up $1,000 as emergency fund. And we will do it fast. To make this happen, you will need to set up a budget for every month. If you think that’s too much work, trust me, it will be worth it. Without a budget, you won’t even know where you money goes to every single month.
You don’t have to set up the perfect budget, because none of us have it. You just need some simple planning for your budget that will document where your money goes to. The most important thing is that once you plan your budget, stick to it.
In which case, you will spend every single dollar you have first before the month even begins.
Plan your spending
What I meant is that you should spend every dollar on paper first before the month begins. Give every dollar of your income a purpose, and dictate where your money is going before you actually spend it.
On paper, income minus spending equals zero every month.
Let’s consider the case of an average Joe. Joe has a fixed employment income of $3,000 and extra side income of $500 per month, totaling up to $3,500 per month. That would be his positive cash flow.
He has monthly mortgage payment of $1,000, credit cards minimum payment of $150, insurance payment with a total of $550, loans payment of $450, and various bills up to $330.
His budget will look like this:
Joe’s Monthly Budget
|Extra Income 1||$500|
|Credit card 1||-$80|
|Credit card 2||-$70|
|Gas, bills and utilities||$-330|
|Foods and groceries||$-800|
|Net Cash Flow|
Joe has a monthly positive cash flow of $220, which he can contribute towards his emergency fund before spending on anything else.
You might wonder why don’t we start with paying off debts first? The thing is if you do not have this $1,000 as your emergency fund, any sort of emergency can knock you off track.
If you are so focused and dedicated on paying off your debts, charging another $500 on your credit card to fix your car will make you lose your momentum and you probably won’t feel good. This might ruin your financial transformation plan altogether.
And of course, this sum of money is strictly for emergencies only – getting a brand new PS4 or ad-hoc vacations don’t count.
Download our free financial budget planner (in excel format) and follow through the steps to work out your own budget. It is a simple monthly budget worksheet that you should be able to complete within 10 minutes.
Track your spending
With the advances in technologies, tracking your spending has become so much easier. If you have a smartphone, you don’t have to painstakingly write down every purchase you make throughout the day. You can simply use your smartphone to track your expenses.
There are plenty of good applications to use for budgeting. Simply head to Google playstore or Apple store on your device and find a money manager app that suits you. For every purchase you make, spend a few seconds and record it in the app immediately.
One good way to prevent over-spending and make sure you stick to your budget is to pay yourself first. Many people save what’s left at the the end of the month, but that’s not the best practice for money management. Instead, you should save first, and spend what’s left of it. You will transfer your emergency fund into a savings account FIRST when you get your paycheck.
For example, Joe figured that he has a monthly positive cash flow of $220 that he can use towards his emergency fund. What he can do is to pay himself that $220 FIRST when he gets his paycheck. Only then he will sort out the remaining money for expenses.
Where to keep my emergency fund?
I like to keep my emergency fund in a separate savings account that is not attached to checking services. I highly recommend that you set up a new savings account dedicated for emergency fund only. Or you could choose to keep it in a sealed metal container, tucked away in a thick coat, at the innermost corner of your closet.
The point is, make it liquid enough but at the same time keep it in a safe and not-so-easily accessible place. Why would you want to put yourself through so much trouble? Because you want to protect you from yourself. I understand that if you have a tidy sum of money in your hands, impulse might take over and you might just spend it on a new item that you will come to regret in just a few days time.
You don’t want that to happen to your emergency fund.
And remember – do not invest your emergency fund. It is meant for emergencies only.
Manage your spending
One little strategy that I like to use is to transfer my non-fixed expenses to a debit card when I get my paycheck.
If I am Joe, after going through my budget, I would realize that I have a monthly fixed expenses of $2,480 (mortgage, credit cards, insurances, loans payments and utilities). These are the expenses that must go out no matter what.
The only non-fixed expenses I have is foods and groceries, at $800 per month. Of course, in real life, there would be a lot more non-fixed expenses such as clothing and entertainment expenses. However, if you don’t have a minimum of $1,000 savings, you probably want to reduce your spending, at least temporarily anyway.
What I would do is that I would sign up for a debit card, and I would load $800 into the visa prepaid card when I get my paycheck. Or you can choose to hold $300 in cash and load $500 into your debit card. It’s your call.
Using a debit card is a great way to keep your spending under control. It is widely accepted, convenient, provide perks and savings and most importantly, it keeps your spending within what you have in your debit card. You don’t have to worry about overspending due to impulse buying. Coupled with an expense tracking app, you can track where your hard earned dollars go to every single month.
For the rest of the fixed expenses, you can choose to set up automatic transfers from your bank accounts to pay the same amount every month. This is not essential but it will save you some time.
Ideally, you would want to save up your emergency fund as soon as possible, within 2 to 3 months. So if you are like Joe, who is very tight on the budget, you would want to go all-out during this phase and save up that $1,000.
You can take up some odd jobs, sell things you no longer need, or skip restaurant meals completely for the time being and cook at home to reduce spending. Or you can earn some cash from your couch during your free time.
At any point of time, you want to have your emergency fund intact. Which is to say, if you spend $500 on emergency car fixing this month, next month you would top up $500 to make it back to $1,000.
If you have followed us up to this point, good job and give yourself a pat on the back! Now you have built a solid financial foundation and you are ready for the next step.
To Do List
- Plan your budget
- Pay towards emergency fund FIRST when you get your paycheck
- Pay off fixed monthly expenses
- Download a money manager to track daily expenses
- Sign up for a debit card for non-fixed expenses
- Speed up the process with an additional income stream
This article is one of 6-step series “Achieve financial freedom in 5 years time“.