Tank #2: Build a 1-Month Emergency Fund
After contributing up to your retirement match, it’s time to build a small emergency fund.
You’ll need fuel.
Here’s an overview of the 1-Month Emergency Fund:
How do I calculate how much I need?
It’s the amount you would need to last one month if you lost your job. We’ll increase this to 3-6 months when filling tank #4. But, to fill tank #2, you need to save enough to cover one month of core expenses. Core expenses include rent/mortgage, utilities, minimum debt payments, insurance, recurring medical costs (like prescriptions), food (think Ramen noodles), gas and basic cell phone. It does not include your HelloFresh subscription, eating out, clothes, your gym membership, etc. Remember, you’re trying to figure out how much you need for one month if you lost your job. All your non-essential expenses don't count.
The amount does not need to be exact. Most people can get by with $2,000 - $4,000 to cover 1 month of expenses. Estimate how much you need and go with it.
Where do I invest it?
Nowhere. Your 1-month emergency fund should be accessible. You can keep it in your checking account or a savings account at your bank. Don’t invest it. You're not trying to use this money to make money (that's what your 401(k) is for). It’s simply your "oh crap fund" for when life happens.
When do I use it?
When you have an emergency: you get a flat tire, your roof springs a leak, you need to bail someone out of jail (you're a really nice person, btw). Emergencies (or bad luck) will always happen throughout your life. If you don’t have savings to cover the unexpected, you risk going into debt or adding to existing debt. That’s not good.
By the way, a new pair of shoes for a wedding is not an emergency. Neither is going out for drinks to catch the NBA Finals. Those are either part of your budget or it’s time to get creative.
What do I do after I use it?
If you use money from your emergency fund, replenish it. If you use $200 from your fund, put it back before moving on with your plan. You will need to fill this tank a few times during the process. Eventually, you’ll have enough saved that you’ll never touch this 1-Month Emergency Fund.
Why am I doing this before paying off my credit cards?
You’re building this fund first to avoid the Credit Card Vicious Cycle of Charges Death Trap (aka CCVCCDT). Yes, it’s as bad as it sounds. It’s an epidemic in the United States. Emergencies with no emergency fund equal more charges. More charges leads to more interest. More interest leads to a deeper hole of debt. It happens to the best of us.
Imagine spending six months paying down your credit cards. You’re feeling good. Then, your car’s alternator goes out, and you need $400 for repairs. If you don’t have an emergency fund, you charge it. Then, your debt goes right back up. It’s frustrating. It’s demoralizing. It’s demotivating. And, worst of all, there’s little you can do.
An emergency fund protects you from CCVCCDT. It gives you a foundation so, when you start paying off bad debt, you don’t have setbacks.