What exactly is an emergency account? And how can you make it one of the primary building blocks to growing and preserving your wealth?
An emergency account (a.k.a. emergency fund, rainy day fund, cash account) is a financial buffer when unexpected expenses arise. Typical items that fall into this category include car repairs, non-covered medical expenses, and loss of income. With regard to loss of income, the usual response is 6 – 12 months of “real” living expenses, as opposed to 6 – 12 months of living the high life. You calculate what this is by looking at your core expenses and immediately eliminating any frills, like dining out, gym memberships (without a contract), etc. We will refer to these core expenses as your Minimum Viable Lifestyle (MVL). Find out what your MVL is by downloading the MVL Worksheet.
So that takes care of the typical financial advice sound bites. Now let’s talk about how all this can be much more than just doom and gloom. It begins with changing your mindset now so that you can leverage your emergency account for financial success later.
When you’re climbing out of debt, you need to run lean and mean. Same goes for your emergency account. There’s no perfect formula for how much padding you need, but Dave Ramsey recommends a “baby” emergency fund of $500 – $1,000 to cover the unexpected while you funnel as much cash as possible to pay off your debts. When I made the decision to go debt free, my emergency account ran at about $1,000 – $1,500, and I was lucky enough to only have to dip into it a few times.
If your minimum viable lifestyle runs a bit steeper, and $1,000 wouldn’t cover much in the wake of an emergency, then use one month’s expenses as your target emergency fund.
Now we’re not tackling how to get out of debt in this post, but when you’re shoring up your first emergency account, pay your minimums on your debt accounts until your emergency account is fully funded to $1,000 or the equivalent of one month’s expenses. By putting a slight delay on debt reduction to fully fund the first tier of your emergency account, you will have a solid line of defense when your attention again turns to eliminating your debt.
When you’re finally out of debt, you’ll feel like a million bucks, but even in those first few months, when you’re already starting to focus more on building wealth and investing, you’ll want to revisit your trusty friend the emergency account. It is now an ally in your quest to keep the investment momentum going, even when unexpected expenses catch you by surprise.
As you revise your monthly budgeting to allocate dollars from debt reduction to investments in 401ks, IRAs, and other items, make sure to allocate 50% of those investment dollars toward fully funding your emergency account to cover 6, 9, or even 12 months of your MVL. Like any investment, your emergency account should be funded consistently until you meet your goal. Know that it may take a few years to complete, especially if you’re shooting for 12 months of MVL protection.
Emergency accounts are too often and too easily written off as “nice-to-haves,” but they are absolute necessities on your path to becoming your own trust fund baby. The first step is calculating your Minimum Viable Lifestyle. If you’re working your way out of debt, keep it simple with $1,000 or 1 month of MVL funds, and put the balance of your free cash toward paying off you debt. If you’re already past debt and building wealth, take your emergency account to the next level with 6 to 12 months of MVL funds by splitting 50% of your investment budget to build your emergency account alongside your other investments.