Why is having an emergency fund a top priority even if your paying off your debts?
If you’ve been following Dave Ramsey and his baby steps method you would have come across the emergency fund throughout the process.
But why is it so important?
Reduce Reliance On Debt
The main reason why an emergency fund is important is because it reduces your reliance on debt to get you out of a bind.
It wasn’t too long ago when I started the debt snowball process by eliminating all our consumer debt. I had a couple of cars that we’re financed yet I had the money in the account to pay them off.
Upon learning about Dave Ramsey and the baby steps process I paid the car loans off in an instant.
But have a guess what happened not too long after making that decision?
Our air conditioner blew up and we also received notice from the government that we had to pay them money for over-collecting on a family benefit we were receiving at the time.
Yes, Murphy’s Law.
When you least expect something to happen – it happens.
So with our debts paid off and a few dramas hovering, I had to tap into our emergency fund. Thankfully we had enough to cover these repairs and payments, but if we didn’t we would have needed to defer the repair, enter into some payment plan with the government or get a short-term loan.
But this was what the emergency fund is for: emergencies!
After fixing the air conditioner, paying the government back in one lump sum we could resume life again and build up our reserves.
How Much Should An Emergency Fund Be?
There are several factors that should help to answer this question about how much you need to have saved for an emergency fund as there is no fixed dollar amount for everybody.
Instead some common sense is needed along with a little analysis on your household spending.
As stated before an emergency fund is there to help in times of emergencies.
If we assume there is a loss of income for what is normally received into the household then how long will it take to restore and how much is needed to keep things going?
Here is how I have calculated how much to have for our own household:
1. Being the sole income earner for our home should I lose my job this would mean a main source of our income gone.
2. While I may be able to get a similar job relatively quickly with COVID being an issue it may take even longer than normal.
3. My wife wants a comfortable barrier.
From these three responses my wife and I decided on 6 months of my income as an emergency fund.
Notice that I said income and not expenses. I’ve personally found it easier to calculate the size of an emergency fund from income rather than expenses.
I found when trying to calculate from expenses a little complicated and I could easily reason for a reduced emergency fund size by remarking that “We’d kill this expense should I lose my job.”
While there certainly would be expenses nipped in the bud should something untoward happen to our overall household income I’d prefer to aim high. The worst case being a large emergency fund, and the only negative I’ve seen with this is missed returns. So what!
The pain of not having enough of an emergency fund outweighs the pain of missed returns in our household.
So does the 6 months of my income include any other income I might earn?
No. It just includes my salaried income.
What if my wife was working?
If my wife was working then we’d reduce the emergency fund down to 3 months of my net pay income. Provided my wife didn’t work for the same employer.
My reasonings are that there’s risk by being employed by the same employer, should they end up in financial trouble and are unable to pay our leave entitlements then there would be two incomes removed from the home.
However, if my wife worked and provided a second income then this would lessen the reduced income from my lost job.
Why not base the emergency fund on your wife’s second income?
Provided we are employed by two different employers that are not in the same group then the emergency fund would only need to be the size of the higher income earning spouse.
Should my wife lose her job then the larger emergency fund based on my higher income would support the family while my wife hunted for another job.
Would your emergency fund size be any different if I was self-employed?
What if income is erratic or seasonal?
I’d calculate an average of monthly income from the last 12 months and then use that number as the basis of my emergency fund.
Is that after taxes?
Yes. Being self-employed would mean I’d need to calculate the equivalent of what my income would be net after taxes.
My reasoning behind this is that I may need to tap into my emergency fund right at the same time I need to pay for my taxes. Therefore, consider the tax when calculating your regular monthly income as a self-employed person.
What if you salary sacrifice?
Excellent question. This is one of the reasons why I don’t like novated leases. If you lose your job what are you going to do with the vehicle? Keep making payments even though you have no income? Or pay it outright?
This is why I love the associate lease provided you don’t have a lease or loan on the vehicle as you’re effectively doing the same as a novated lease but are giving it a different name.
So if you do salary package a novated lease then you need to have a strategy on funding this should you lose your job. If you want to keep the car then I’d start building a car emergency fund to help pay it off.
You could also use your unpaid annual and long service leave entitlements as your car emergency fund. As these will be paid to you should you be laid off (provided it’s not for misconduct or any other reason that could prevent payment of your entitlements).
Your payslip should contain details about your current leave entitlements, if not ask your payroll department for up to date details.
However, if using leave entitlements as your car emergency fund there are a few things to note:
1. You need to have leave entitlements. If you consume all of your leave then you cannot rely on this strategy to help provide for payment towards your lease.
2. When being paid your leave entitlements assume the tax payable will be the worst case: therefore halve your calculated entitlement.
For example, if I have 129 hours of annual leave available and my hourly rate of pay is $50 per hour, then my gross pay will be 129 x 50 = 6,450. If I assume half as payment then I will likely net $3,225 in my bank account.
Another strategy could be to sell the car, however, I’d still be building up a car emergency fund in case the price I get for selling the car cannot pay for the outstanding balance of the novated lease.
If though I’m salary packaging superannuation or other expenses then I’d only consider my net pay.
If I’m also seeing storm clouds brewing on the horizon with my job then I’d be cutting the superannuation salary sacrifices and any other salary packaging arrangements (if possible).
You want to be storing up cash, especially if you have a novated lease. I’d make enquires on what the lease payout currently sits at and use that as a guide with whatever strategy I decide to do (payout or sell).
Benefits Of A Fully Funded Emergency Fund
Once our family finally achieved a fully funded emergency fund there were several benefits we didn’t initially think about which happened.
First, insurance bills got cheaper. I could afford paying annually, which is cheaper than paying monthly, and I could increase the excess (or deductible) as I could contribute some of my own savings toward the repairs.
Another benefit was due to the structure of our mortgage and having multiple offset accounts to reduce the principal. By having an emergency fund and using the account as an additional offset it has helped to reduce the interest expense of our mortgage.
One other benefit if you can call this a benefit is that once we had an emergency fund in place our perspective on what to purchase changed. No longer were we limited to buying something we could only afford. If we wanted to buying something that was a little more expensive we now had the option and could buy those things.
It could be said that this was always an option regardless of whether we had an emergency fund or not, but when you do buy something expensive there’s a tinge of guilt knowing you could have paid for the cheaper one and put the money to better use.
An emergency fund is a great way to be in control of your finances and to help buffet any costs that you may incur in life without resorting to debt and interest charges.
The reason why an emergency fund should be a top priority for your household is that it helps to reduce stress, especially during uncertain times of economic stability and job security, it reduces some other expenses when done right, and helps you to stay out of debt.