Based on the post i made on financial independence, i will be doing elaborate posts on all the 8 steps in my financial independence post. This post is covering the third step to financial independence, which is building an emergency fund.
The third step to financial independence is building an emergency fund. An emergency fund is to ease your mind of huge unexpected expenses.
Would’t it be cool if you never had to care about getting fired, laptop breakdowns or a dead phone? An emergency fund is a way for you to control uncontrollable situations. If you are being laid off, you have bills to pay and without a job that could be difficult. If your cars motor blows, which can be expensive, you have to fix it! Which is why you need an emergency fund.
What is an Emergency Fund?
An emergency fund is a savings account for unexpected expenses which your budget cannot cover. The idea of an emergency fund is that you have your mind at ease, so you can worry about other non-financial matters.
The emergency fund is for actual emergencies, not if you see a nice shirt when shopping. We are talking roof leaks, hospital visits, etc. I am sure we have all tried it, and would rather not experience such a situation ever again. Here the emergency fund saves you.
The emergency fund is cash. The emergency fund should not be stocks, index funds, or other investment types. The idea of an emergency fund is that you can keep the value, no matter your, or the world economic situation. E.g. if you had your emergency fund in stocks, and a financial crisis hit. You would most likely lose both your job and most of your stocks value = no emergency fund value.
Statistically, Why Would You Want An Emergency Fund?
No matter if you are going for financial independence or the average life, you have to have a emergency fund. Here is why:
According to finder.com 52% of people taking out payday loans because they experience unexpected expenses. Furthermore, 19% taking out the payday loans because they had a unexpected decrease in income.
According to Vangaurd 56% percent of Americans would not be able to pay for 3 months worth of expenses. Furthermore, 26% had unpaid medical bills. I would not want anyone in the world to be in a situation where they cannot pay for medical treatments.
Everyone needs an emergency fund. No matter your income bracket, you can face costs which cannot be paid with a monthly salary.
How Much is Enough For Your Emergency Fund?
Typically you will hear that you should build an emergency fund of 3, 6, 9 or 12 months worth of expenses. The amount you are aiming for, is very personal and therefore, just saying 6 months is not enough.
Therefore, when figuring out how big your emergency fund needs to be, you need to consider the following:
- Income type
- If you rent or own (both car and house/apartment)
- How many incomes are in the residence
- Living expenses in your country/region
- The maintenance costs of your possessions
- Unemployment benefits
The size of the emergency depends on 5 listed above.
1. Income type
If your income is based of commissions you should start to identify some key highlights:
- Your industry seasonality
- Economical state of the world
- Other incomes in your residence
The first to consider is the seasonality in your industry. Lets face it, if you are on commission for hunting, you will be getting most of your commission in the start of the hunting season. Throughout the hunting season you might experience a stable income, whereas when the hunting season ends, you commission will most likely end to.
Looking at the economical state of the world is important because it tells you about peoples willingness to spend money. Therefore, if the economy is bad, you commission will most likely be bad.
In a home with a working mom and dad (F**k political correctness. A couple, okay?) it is easier to provide for your entire residence (kids, maintenance, cars, etc). If both you and your partner is on commission income, you need a way larger emergency fund, in relation to if you were on just two stable monthly incomes.
2. If you rent or own
If you rent or own can have a big impact on your emergency fund. When renting you would typically experience that the landlord is liable for major damages. Any wear and tear damage is typically covered by the renter. This is one of the upsides to renting. If the roof starts to leak, the landlord has to pay. Whereas, if the toilet seat cracks, you have to replace it. Looking up the price of a toilet seat on amazon, i would much rather pay for a toilet seat, rather than a new roof.
3. How many incomes are in the residence
This was discussed briefly in the 1. consideration to your emergency fund.
However, there is a major difference in being a single provider of a residence, or living with 5 roommates. The less incomes there is in the residence at which you live, the higher your emergency fund should be.
4. Living expenses in your country/region
If you are living in a country with minimal living expenses you might not need a just as big emergency fund, whereas if you live in a expensive country you might need a higher emergency fund. 1
In my home country an apartment in the capital typically cost around 1.350 EUR to rent. Whereas, an apartment in the third largest city costs around half (670 EUR).
While expensive countries/regions often pays higher wages to compensate, you should look for living expense indexes such as world.data.
5. The maintenance cost of your possessions
If you have any hobbies you should consider the costs of maintaining those in to the emergency fund. This could be boats, project cars, gaming computers, DIY (do it yourself) projects, etc.
Consider the priority of your possessions, if you are to be unemployed or something critical for your hobbies break. If it is critical for you to have the hobby while being unemployed, this should be accounted for in the emergency fund.
6. Unemployment benefits
If you are covered by an unemployment insurance, or have governmental unemployment benefits, you have to consider the size of the cash you can get from such unemployment benefits.
The amount which can be provided varies a lot between countries and insurances.
The right size for YOU
Only yourself has any perception as to what the size of an emergency fund you would need. Each person on earth is unique to their own, on how they have created their lifestyle.
With the six perspectives in mind you should figure out what you would include.
Using myself as an example, (1) i live of an stable monthly job payment, with educational finance support, (2) I rent, (3) There is two incomes in my residence, (4) living expenses are high, (5) maintenance cost is fair and (6) I am already an bachelor in engineering, and studying for a masters degree (engineers have some of the lowest unemployment rates), furthermore i am well insured.
Personally, i have said i need 6 months worth of expenses for month-to-month costs. This means all of my fixed costs, such as housing, groceries, etc. Things i cannot live without. Then i include €270, because this our “own risk” costs if something breaks, such as a laptop. I own no car or other “critical” day-to-day tools, which is expensive to replace/repair.
The third step to financial independence is to create an emergency fund. Provided with a lot of examples i hope to have scared you into saving for an emergency fund. While the third step to financial independence is not rocket science and actually really easy to do, not a lot is doing it. Therefore, i hope you take my advise and start building that emergency fund right now. Even on a low income, start setting aside.