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Consumer Blog

A step-by-step guide to building an emergency fund

A person without an emergency fund is like a frog sitting in a pot of cold water that is slowly being brought to boilIf you drop a frog in a pot of boiling water, it will of course frantically try to clamber out. But if you place it gently in a pot of cold water and turn the heat on low, it will float there quite placidly. As the water gradually heats up, the frog will sink into a tranquil stupor, exactly like one of us in a hot bath, and before long, with a smile on its face, it will unresistingly allow itself to be boiled to death.

Of course, this has never been scientifically proven because it’s very hard to get a frog to sit still for hours. It is, however, very easy to get a human to sink into debt.

It’s human to take things for granted. 

We often don't appreciate things until they are gone. That's what happened to Peter when his fridge stopped working.

His wife Susan was a homemaker. To save money, she cooked meals for the family and froze leftovers in the refrigerator. One day, the fridge stopped working, so she called Peter in the office.

"Honey, the fridge broke down," she said. "We have to buy a new one or the food will spoil."

This small emergency cost Peter $2,000 as he had to buy a new fridge that same day. It couldn't wait.

This small emergency would have set 47 percent of Americans in debt as they would have to borrow money or sell something to meet an unexpected $400 expense.

If Peter had a savings habit, he would have dipped into their savings to tide him through this emergency.

Yet some people live from payday to payday.

The first thing to do after payday is to save, not spend.
Image credit: 9gag

Such people may not have any savings to dip into, and would likely have used a credit card to pay for the new fridge. Now we’re not against the use of credit cards per se. Smart spending with credit cards can actually save money if used wisely.

However, when we use credit cards to pay for something we cannot afford, credit cards can make the problem worse.

The underlying problem is that we spend all that we earn, leaving nothing to cushion an emergency expense. To address this problem, we set aside some money that we can dip into in case of small emergencies.

Here's an example of how it works:

Peter earns $4,000 a month. Every month, he puts $800 into his emergency fund and spends $3,200 on his family. After 1 year, Peter has built up $9,600 in his emergency fund, which is equivalent to 3 months of family expenses.

Peter saves $800 each month to build his emergency fund

If a small emergency takes place, such as having to buy a new fridge for $2,000, Peter can dip into this fund and pay for it. It would take him 2½ months to replenish his fund. But at least he won't go into debt.

With an emergency fund, Peter can pay for a new fridge without going into debt. 

 Conversely, let's look at Mary who spends all that she earns every month. It doesn’t matter how much she earns, but let’s say it’s $6,000.

Mary has no emergency fund. She spends everything she earns.

When an emergency happens and she has to spend $2,000 to replace her fridge, she has no savings to dip into. She uses her credit card to pay for the fridge first.

When Mary runs into an emergency, she uses her credit card to bail her out.

When her bill comes the next month, she still doesn't have $2,000 to pay for it. She scrounged up enough to pay just the minimum sum on her credit card bill, which is $100.

That one rescue would take her 4 years to pay off.

 

Mary did not have $2,000 to spare for a small emergency. What are the chances that she will encounter a similar situation again in the next 4 years?

Because she has no emergency fund, Mary keeps relying on her credit cards to bail her out. She is turning into a frog.

 

What will happen if Mary loses her job, and hence her source of income? How will she afford her family expenses and pay her credit card bills? Most likely, she would take on even more credit card debt, spiralling further and further into debt until it’s too late.

If you are already trapped in the spiral of credit card debt, it is imperative that you get out of it as soon as you can. If you have credit card debt and you’re paying only the minimum amount every month, do you know how long it would take you to pay off the debt?

If not, download our free Credit Card Debt Repayment Predictor.

After finding out how many years it would take you to pay off your credit card debt, it might be tempting to start paying off more than the minimum amount to reduce your balance.

That would be like spraying water onto the flames of a burning fire. What is more important and urgent is to address the root of the problem - the lack of an emergency fund, so that you do not fall deeper and deeper into debt.

How to start building your emergency fund

The most important thing is to first develop a savings habit. A rule of thumb is to have 3 to 6 months of expenses. Let’s start with 3 months, then build your way up to 6 months.

There are two ways that people use to save money.

METHOD ONE: Spend first, then save what’s left.

In order to know how much to save, you need to work out how much you’re currently spending and on what.

To help you out, we’ve created a Cashflow Maximiser, which contains almost every category of expenses that you might have.

If you’re not sure where your money goes, spend a month tracking every single expense you have and record it on the Cashflow Maximiser. In the free spreadsheet, you are also asked to enter your income sources and amount.

Your surplus is the key to learning how to build an emergency fund

 

To have an emergency fund of 6 months expenses, divide the yearly outflow by 2.

Let’s say Peter wants to build an emergency fund of 3 months expenses, which is $9,600. From the Cashflow Maximiser, it is clear that he would need to save for 1 year to reach this goal.

This is the first way of building your emergency fund.

However, if you’re like Mary who spends everything that she earns, you may not have a surplus at the end of the month. Then how would you build your emergency fund?

METHOD TWO: Save first, then spend what’s left

If you’re spending $6,000 a month, then you would need $18,000 to have 3 months of expenses in your emergency fund.

If you want to save $18,000 in 1 year, you would need to save $1,500 a month. Set up a standing instruction with your bank to transfer this amount to a separate account on the day that you receive your salary.

A standing instruction tells your bank to transfer a certain amount of money from one account to another

This makes sure that you save first. Then, spend the rest of the money that’s in your bank account as you normally do. You will definitely see a drop in your lifestyle because you have less to spend, and you must resist the urge to use your credit card to make up the difference. After all, this is the very situation you’re trying to avoid.

If saving $1,500 a month is too much for you, try saving $1,000 a month over 18 months instead of 12. You can use the Cashflow Maximiser to help you decide what areas of your expenses you can cut down on.

The benefits of having an emergency fund

Besides paying for small emergencies, building an emergency fund also instills in you a very important savings habit. This habit of saving money will be instrumental in achieving all your financial goals.

Now when we do holistic financial planning, we take into consideration your other financial concerns and goals as well. But let’s say you’ve gotten that taken care of and you just want to focus on planning your income protection only.

Having an emergency fund is the first line of defense in protecting your income against various threats. It gives you peace of mind knowing that should you lose your source of income because of, say, retrenchment, you have a few months savings to tide you over while you search for another job.

It can even give you the freedom to leave your job when working conditions become unbearable. A person without an emergency fund cannot leave their job no matter how badly they wish they could, without going into debt.

If you’re self-employed, having an emergency fund also helps you to tide through periods where you have no income either because of an illness, an accident, or simply no business.

Having an emergency fund equips you to take on life's small emergencies. 

 

Now that you know how to build an emergency fund, you can get started on building your first line of defence when it comes to protecting your income. To find out what the other four lines of defence are, download our free eBook The Secret To Income Protection.

 

Download eBook The Secret to Income Protection

 

This blog post is an excerpt of Chapter 3 - "Honey! The Fridge Broke Down" and other emergencies of The Secret to Income Protection.

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