Just Start Building Your Emergency Fund

Building and maintaining your emergency fund is one of the earlier actions you should take as you start building your wealth. It may not seem like it as emergency fund assets are usually invested conservatively, so it won’t be a large source of growth. However, it will be a cornerstone in your wealth strategy to protect your assets that are meant to grow, limit your need to go into debt, and give you peace of mind.

It should be noted that if you have a family, having proper life and health insurance should likely come before building your emergency fund, and of course having a will prepared by your attorney is critical. Additionally, paying down high interest debt is critical, as the interest charges on that debt will accumulate fast, so it is best to eliminate this source of wealth destruction. After these actions are complete though, just complete the task of building your emergency fund.

There are various approaches to designing an emergency fund. Typically you should have 3-6 months of living expenses saved, and if you have a family, have a couple months more than that. These assets should be liquid, FDIC insured, and you should view these assets as something you only touch for their intended purpose: emergencies.

One of the top reasons is to have some backup assets in the event of a sudden loss of income. A job loss can be devastating on a number of levels, and you will be happy to have this lifeline during this difficult time. This fund will allow you to keep supporting your family and avoid having to ask friends/family for money or reach into debt to pay living expenses. Also, it will allow you the time to find a new, strong job that you are qualified for, not just the first opportunity that comes along.

Paying living expenses in the event of a job loss is not the only reason to have an emergency fund  though. Having this fund will also limit your need to go into debt as high, unexpected expenses inevitably occur in your lifetime. These could be health expenses, home repair or auto expenses, or a multitude of other surprises that occur as life happens. 

For example, if your water heater breaks, it will on average cost you $1,500 to replace. If you don’t have an emergency fund, you will likely need to pay for this with a credit card. Also, since you don’t have the funds to pay this off, you will be paying very high interest charges on this  purchase. If you have good credit, you will be paying about 19% interest on this charge, so over the course of one year, this cost of this water heater isn’t $1,500, it is $1,785 once interest is factored in. This is how the credit card doom loop starts, as you don’t have the funds to pay  the initial expense, so you take on debt, now you don’t have the funds to pay the expense or  the interest, and you sink further underwater. It’s impossible to predict what these inevitable expenses will be or when they will happen, but just assume they will occur by preparing now so you avoid this situation.

Another reason to have an emergency fund is to avoid interrupting the compounding of your investment portfolio. I wrote last week about how compounding is making your money work for you, not your working for your money. You should try very hard to avoid interrupting that powerful force, as even little interruptions will have long term implications on your wealth.

In last week’s example, we assumed a 40 year time horizon, a balanced investment strategy earning 5% per year, with contributions of $2,400 at the beginning of each year. At the end of this horizon with no interruptions, you have a balance of $304,414. If we assume in year 3 that we contribute $1,500 less than we otherwise would, our balance at the end of the 40 year horizon would shrink to $294,837. This is almost a $10,000 difference in account balance, showing how interrupting the compounding of your investment portfolio has huge long term consequences. If you could have tapped your emergency fund instead to pay this expense, you could have kept your compounding intact.

The task of building an emergency fund is easy to put off, as those funds could easily be used for more enjoyable things, and additionally the funds are allocated to a low interest bearing account, therefore not explicitly growing your wealth much. But you only need enough for an emergency, and in this case an ounce of prevention is worth a pound of cure. As much as we expect our life goals to go exactly to plan, we all know our paths in reality take many unexpected twists and turns, let your emergency fund make that ride smoother.