Everyone knows that it’s important to have an emergency fund. Why? The obvious answer is so you can dip into that money when you need it.
The not-so-obvious answer is that an emergency fund is a fundamental part of financial planning. In fact, you can argue that emergency savings is SO important that you can’t really implement the rest of your financial plan until you have enough in emergency savings, or at least a sound plan to get there fairly quickly.
Why is an emergency fund such a fundamental part of financial planning? Below are several reasons.
1. Not having an emergency fund is a strong indicator that you might be living above your means. If that’s the case, you have a LOT to fix, and you probably don’t even realize it.
When you’re living above your means for a long period of time, any financial planning you do will eventually fall apart. If you think about it, everyone falls into one of three categories, regardless of income:
- Living below their means. This means saving some amount of your income as you get paid. A good rule of thumb is to save at least 10% (or more) of your income. This would mean that you’re living on only 90% of your income, right? Even if you can’t save 10%, saving ANY amount is better than either of the next two.
- Breaking even. This means living paycheck to paycheck, or living on 100% of your income. You’re not racking up credit card debt, but you’re not setting aside anything for a rainy day, either. You might wake up in 20 years (or sooner) and wonder what happened to all your money. If you’re in your twenties, you’ll reach your forties and wonder if you’re on track for retirement (you won’t be, if you keep breaking even). If you’re in your forties, you’ll be in your sixties wondering if you’ll EVER retire. But at least you’re not in the next category.
- Living above your means. This means you’re spending money as fast as you can make it, and adding debt because that’s not enough. You’re living on over 100% of your income. It doesn’t matter how much you earn, because living on 105%, 110%, or more, of your income will eventually catch up with you.
If you feel like you’re putting out fires every day because you’re financially stressed, you’re in crisis management mode. A prerequisite to financial planning is ensuring that you’re no longer in crisis management mode.
However, you’ll never get out of crisis management mode unless you take control over your cash flow and start living on less than 100% of your income. Until you do this, all the financial planning in the world doesn’t matter a bit.
2. Just because you started an emergency fund doesn’t mean that you’re in the clear.
Google ‘emergency fund’ and you’ll get 20 pages of articles by personal finance bloggers on “how to” hacks. However, it’s not that easy. If it were, these articles wouldn’t get 50,000+ views. People would just start saving, get their emergency funds squared away, and press on.
The hard part is sticking to that plan. Just because you started a fund doesn’t mean that you’re prepared for an emergency if it happens the following month. Because life happens, bad habits creep back into our lives, or we simply have bad days…just starting an emergency fund isn’t the same as having one. Even having a solid plan isn’t the same. But it’s a little better than not having a plan, or having just started.
On the other hand, when you have an emergency fund, you’ve proven that you’ve addressed any bad financial habits that prevent you from saving money in the first place. Not only that, but you’ve been able to consistently set aside money over a significant period. Finally, you’ve probably got a better handle on what constitutes ‘an actual emergency.’
3. People who build (and maintain) an emergency fund usually have a good definition of what ‘an emergency is.’
Everyone has a different definition of what constitutes an emergency.
Some things are obvious emergencies. Medical emergency-check. Deductible for an unanticipated home or car insurance claim-check. Sudden job loss-check.
Some things are obviously NOT emergencies: New clothes, impulse purchases, etc.
Things in the middle: Should I (or should I not) pay off my credit card? I’ve got some extra money this month—should I make an extra car payment?
While everyone encounters similar situations in different ways, most people can agree that an emergency fund should be used when something is unexpected, urgent, and necessary. The difference is usually in how people define urgent and necessary. People who maintain an emergency fund have addressed these questions for themselves by establishing (and sticking with) a policy that works for them.
People who struggle with their own definition of urgency and necessity might not be able to see the benefits of long-term delayed gratification. And delayed gratification is key to making some of those important financial planning trade-off decisions.
4. If you can’t delay your own gratification long enough to build an emergency fund, how would you expect to build your retirement fund (or reach another long-term savings goal)?
And this is the crux of the true importance of an emergency fund, as it relates to financial planning. It turns out that much of the financial planning part is simple. While financial planning has complexities and nuances, the real difficult part comes in actually doing it. When your plan includes cutting $300 in monthly expenses so you can start building your emergency fund, you actually have to figure out where that’s going to come from. If you can’t do it for an emergency fund, which most people say should include 3-6 months of living expenses, then how do you expect to do that for a retirement fund (which should help you live the rest of your life after you’ve stopped working)?
The bad news is that this is a hard mindset to fix. The good news is that once you get used to the thought of delayed gratification, it becomes easier to focus on those distant goals. And once those goals become easier to focus on, they become easier to reach!
Before any true financial planning can take place, you must first demonstrate the discipline to save enough money for an emergency fund. However, once you’ve done that, or if having enough cash has never been an issue for you, then it might be worthwhile to look at your entire financial situation. That way, you can rest assured that your money is working as hard as it can to support your best life!
Are you ready to take that next step? It’s as simple as scheduling a complimentary, 30-minute consultation with us. During that time, we can talk about your financial concerns and goals. We’ll also determine if working together is the right thing for you. Feel free to schedule that appointment!