My eighth rule of budgeting: Budget for emergencies and define emergencies in writing!

by Nick on August 6, 2010

This one is tricky for a lot of people.  Let’s first talk a bit about emergencies, what is an emergency (to me) and what is not an emergency (to me). 

First and foremost, emergencies are beyond your knowledge and control.  They are things that “happen to you or people you love.”  They are sudden.  They are not predictable.  And by “not predictable” I do not mean something that you knew was going to happen soon, but just didn’t know exactly when.  I mean things you had no idea were going to happen any time soon – or ever.

Emergencies (in no particular order):

  • a car accident;
  • your car that you actually need all the time and that is in relatively good condition (or better) breaks down or requires necessary repair;
  • physical injury;
  • an unexpected pregnancy;
  • a fairly-new refrigerator, air conditioner or heater breaks;
  • a natural disaster causes damage to your house;
  • an unexpected job loss or cut in hours or pay; and
  • an unexpected death.

I’m sure I’m missing some, but you get the gist of it?  They’re things that you could not have predicted no matter how hard you tried.  You can’t predict car accidents.  And accidents cause financial (and sometimes other) damage that may need to be addressed.  (You shouldn’t “need” to tap into your emergency fund to fix scratches or a bent fender no matter how “pretty” your car is unless there is some other compelling reason, for example.)  You can’t predict a one-year-old refrigerator breaking (and you need to have a running refrigerator).

But if your cigarette lighter in your car unexpectedly breaks, that’s not an emergency!  It’s probably a sign…  But if someone steals your headlights that may be an emergency (if you drive at night… and, yes, this one is based on real life).

Not emergencies (in no particular order):

  • Birthdays (you know when they’re going to happen every year);
  • Holidays (same);
  • an unbelievable sale on [insert pretty much anything here].  I mean even a once-in-a-lifetime, 80% off that suit I’ve been eyeing for months! (This is not a reason to tap into an emergency fund.  What happens if there is an emergency the next day?);
  • a wedding (even yours!  These are things for which you should plan and budget, not tap into an emergency fund.  If you will be left without an adequate emergency fund (more on that later), you cannot afford the wedding.  Scale back.  It’s OK.  Deep breaths.  It’s about your and your spouse, not the 2004 Cabernet that your Uncle Wine-o really likes…).

Again, you see the pattern?  Ask yourself the following questions when you’re considering tapping into your emergency fund:  Could I have predicted this?  When did I find out about this?  How could I have saved for this?  If you could not have predicted it, just found out about it and could not have saved for it, then it may be an emergency. 

Then ask yourself:  Do we “need” [whatever] right now?  And can this wait?  If it cannot wait and you need [whatever] right now make sure you understand why.  That’s the key.  But if you don’t have a good answer to “why” it could not wait it may not be an actual emergency.

So what’s a good answer to why?  It depends.  I get a little hokey with this too.  I think about my family and whether I would feel comfortable spending that money and not having an adequate emergency fund.  So far, we haven’t had anything that was so unpredictable and necessary that we’ve had to tap into our emergency fund.  Knock on wood, but the emergencies have been small enough that we’ve been able to cash flow them.  Careful planning.

What’s an adequate emergency fund for me:
This depends and changes.  Right now, one year of living expenses is the right amount for me.  Why?  Because the job market is terrible and I have people I support.  If they were handing out jobs to replace mine like menus at the street corner, maybe I would feel comfortable with six months.  If my expenses go up (GASP!), I need to save more.  If they go down, I could reduce it.

How I manage my emergency fund:
What if I want to buy something (a house, a car, a vacation)?  Simple.  Let’s take a house for example. 

For this example let’s assume one year of living expenses is $36,000 and I have $36,000 in an emergency fund savings account and another $30,000 in other savings. 

If I need to put $50,000 down on the house to have the same $36,000 per year of living expenses, I cannot afford it even though I have the down payment and my expenses would not rise.  Why?  Because I would only have $16,000 in savings left (minus closing costs…).  I would not be ready for an emergency. 

But if instead of $30,000 I had $80,000 in other savings, I would consider making that purchase even if my costs would go up to $50,000 pear year (assuming I could cash flow the $50,000 and still work enough towards my goals) because (and here is the key) after the purchase the numbers would still work. 

I would have $50,000 in annual living expense that I could budget for.  I would increase my emergency fund to $50,000 using $14,000 from my other savings.  And I would have $16,000 left in other savings (minus closing costs).

Here is how the numbers look:

First example:

Before:

  • $36,000 expenses
  • $36,000 emergency
  • $30,000 savings

After:

  • $36,000 expenses
  • $16,000 emergency (minus closing costs)
  • $0 savings

So taking the “after” as a snapshot, I would avoid that purchase.  Not enough emergency funds for me in this economy.

Second example:

Before:

  • $36,000 expenses
  • $36,000 emergency
  • $80,000 savings

After:

  • $50,000 expenses (that still fit into my financial plan)
  • $50,000 emergency
  • $16,000 other savings (minus closing costs)

The “after” snapshot is much rosier in the second scenario. Still having an adequate emergency fund after a purchase is required before I make that purchase.  It may be too conservative for some, but it’s worth it to me.  I sleep better at night this way. 

There are other ways to slice up these numbers.  The same point can be made with the second scenario without having more savings.  For example, if $50,000 down would pay for closing costs and reduce my annual expenses to $16,000, I would consider buying the house because I would have $16,000 in annual expenses and $16,000 in an emergency fund.  You see my thinking?

Does anyone have another take on any on this?  So save up for emergencies.  And know what emergencies are and are not.  How do you save up an adequate emergency fund?  There are a lot of ways.  But the first step is easy – say it with me:

Until next time – put the credit card down and slowly step away from the mall!

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