In early 2015, the Consumer Finance Protection Bureau proposed a framework for understanding financial well-being in terms of four elements.
The first two have to do with financial security: feeling in control of your monthly expenses and being able to absorb unpredictable financial shocks.
The other two are in regards to financial freedom: being on track to meet goals and having the flexibility to make choices.
I want to talk today about the second principle: being able to absorb financial shocks.
Some of us seem wired to worry about money and finances. You know a small amount fear can be a good thing, but it can also quickly snowball into a negative, energy-draining phenomenon.
Start by asking yourself a series of questions:
- Do you have a particular scenario or maybe a list of scenarios in mind when you worry about a future financial shock?
- If this or another shock were to actually come to pass, what do you think would be the ideal resolution?
- Also, what resources would you need in order to handle a surprise hardship? By resources I mean cash savings, health insurance, and unemployment insurance, or even other non-financial assets like your job skills.
- What measures do you need to take to absorb the kind of shocks that you find most worrisome and keep you up at night? After all, if this is keeping you awake at night, it’s about time you got some well-needed rest.
These worries could be anything from unexpected medical expenses, car or home repairs, emergency travel related to family crises, or job loss.
Defining your particular fears and talking about them with a financial advisor is also something to consider. It will help to identify unrealistic versus reasonable financial fears and what plan should be put into place to better put you at ease.
There are at least two ways to prepare for a financial emergency, the first is putting aside money for an emergency fund. I know that putting money aside can be difficult for some as it requires discipline to saving a certain amount of your income until you have a decent emergency reserve. If you listen to my show, you know I always stress having a suitable emergency fund at hand as it will prevent a lot of devastating financial mistakes that could hurt you for years. Try to put 20% of every paycheck aside to reach your goal and if you can do this automatically through your bank, so much the better.
The second is having a backup plan, taking steps to ensure that you have the confidence, skills, and grit to handle sudden financial challenges which may require more than a monetary solution.
Both strategies avoid resorting to credit cards and other types of borrowing in order to stay prepared ahead of time.
Emergency Fund: How Large and How to Save for It
So, just how much is enough for an emergency fund? There is a lot of advice out there. For starters, you’ll want to know how to figure how much money needs to be set aside, and, of course, how you’ll implement the plan to reach that goal.
Many financial planners recommend setting aside at least six months of income into an emergency fund, sometimes up to nine months if you’re a freelancer or your work is seasonal or irregular. This holds true even if you’re eligible for unemployment insurance. Unemployment insurance can be immensely helpful in allowing you to leave your rainy-day fund more or less intact.
Health insurance is a huge topic in its own right, but knowing what your deductibles are will give you a ballpark idea of how much cash you’ll need on hand in case you have a medical emergency.
If your deductibles are high, talk with a financial advisor or someone from your human resources department about health savings accounts. These can make a real difference by alleviating a cash crunch if you or a family member require sudden medical or dental attention.
As far as saving for the emergency fund, the exact percentage of income that you should divert into savings is going to vary some based on factors like what kind of retirement programs your employer offers and how much credit card, student loan, or other debt you’re carrying. Generally, it’s a good idea to pay off debts first because of the interest and the knock-on effect on your credit score (which will determine interest rates for any future borrowing). If your work provides a matching 401k you should participate in that as well.
One simple approach, as I mentioned, is to take 20% of your income each month and sock it away into a dedicated emergency savings account. If you can afford to, allocate more to savings to reach your goals faster. At some point, you will probably be presented with situations where you’re tempted to withdraw from your emergency fund, but which really don’t meet the criteria of a true emergency. Needless to say, resist these urges as much as possible. You don’t want to sacrifice long-term peace of mind for short-term relief.
And, as always, anyone can benefit from discussing their particular situation with a financial professional.
Financial Emergencies and BackUp Plans
Lastly, in order to fully insure you’re prepared for any financial emergency, consider scenarios where your emergency fund might not cover all the costs right away. This exercise will help you develop backup plans well in advance of needing them. For example, if you find yourself facing expensive car repairs or the need to replace your vehicle altogether, can you figure out a temporary solution to your work commute that involves public transportation and/or biking?
More seriously, imagine losing your job. Even if it’s not the sole source of income—because you have a second job, let’s say, or you’re eligible for relatively good unemployment benefits—this kind of shock can get out of hand fairly quickly. The emotional toll can be unexpectedly high, and many people are thrown into depression, anxiety, and acute uncertainty. However, if you’ve already delineated a plan to help you climb back up on the horse, so to speak, and you’re ready to hold yourself accountable to it, you stand a much better chance of evading the quicksand of unemployment. This could be as basic as forcing yourself to apply to 10 new jobs per week, whether in the same line of work or something wholly unrelated. Or it might be more complex, like drumming up freelance work or branching out into a different field that you have some experience or expertise in.
Obviously, these require some legwork beforehand to put into practice in a timely way. Cultivating relationships with prospective freelance clients or enhancing your skills in a new area, maybe through continuing education, could put you in a much better position to deal with unexpected loss of income.
The dividends of being prepared for a financial shock by means of emergency funds and backup plans are profound, even if they’re never drawn on.
I’m inclined to agree with the Consumer Finance Protection Board that they do constitute a fundamental part of financial well-being—and that is a worthy goal to shoot for indeed.