First, it was a U.S. government shut down and then it was a worldwide pandemic. The last few years have taught me that I need to stay prepared for unexpected events. That’s why I have an emergency fund.
Today, so many businesses are closed, people are staying indoors and a lot of fun activities are canceled. I don’t know if anyone saw this coming. That’s why, in addition to an emergency fund, I also have a plan to protect my financial security. My plan has three lines of defense and gives me confidence that I can survive any financial emergency even if my emergency fund is not enough.
In this article, I am sharing tips to help you prepare for a financial emergency and advice you can use if you are in the midst of a financial emergency.
First Line of Defense: Your Emergency Fund
An emergency fund should be a part of everyone’s financial plan because it’s what saves your budget when you have unexpected expenses or a loss in income.
An emergency fund is an account holding cash (not stocks or investments, which can lose their value in a market crash) you set aside for an emergency. Emergency funds are for unexpected expenses such as car and home repairs, medical emergencies, or your bills after you lose your job or have a reduction in income.
It’s crucial to build your emergency fund over time so you have savings available when you need it. The best way to build your emergency fund is to make consistent deposits to your account after each paycheck.
Why do you need an emergency fund?
Your emergency fund can help you survive life’s surprises. And yet, so many families in America do not have $400 saved for an emergency. So any unexpected expense wrecks their budget and can jeopardize their financial stability. To set yourself up for financial success, make sure you have enough in your emergency fund to cover your essential expenses and unexpected bills.
A financial emergency can come in many forms. It could be a layoff that causes you to lose your income or a health issue leaving you with a huge medical bill and possible time away from work. Your car could break down leaving you with a huge repair bill or a huge down payment for a new car.
Whether you are single, married or a parent, you need an emergency fund. When you have funds set aside for life’s unexpected events, you can avoid using credit cards or, worse, payday loans to make ends meet when times get tough.
How much do you need in your emergency fund?
It’s easy to calculate how much money you need in your emergency fund. First, start by adding up all of your household’s monthly expenses. Make sure you have a sound understanding of how much you spend on essential versus discretionary expenses each month.
Now, take that number and multiply by six. So, if you spend $5,000 each month, your emergency fund should have $30,000. Saving $30,000 may take time. So, at a minimum, you need at least $5,000 or one month of your monthly expenses in your emergency fund, in case you have a financial emergency. Then, over time, strive to save more until you reach $30,000.
This means you will be able to live for six months comfortably if you suddenly lose all your income. It’s also big enough that if a large one-time expense comes, you’ll be able to pay for it and pay yourself back over time instead of struggling to find the money.
Save your emergency funds in a high yield savings account that offers competitive interest rates. Since this money is only for a financial emergency, you can take advantage of these accounts and let your money sit and grow. Avoid stocks, bonds or other assets that can lose their value. If your emergency comes at a time when the stock market drops, you don’t want your six months of savings to suddenly turn into four.
Second Line of Defense: Cut Spending & Make More Money Side Hustling
When times get tough, discretionary spending should be the first place where you cut back. Then, you can focus on using your emergency funds on essential costs like your mortgage, food and medicine.
Keep a positive mindset and remind yourself often this situation is temporary. In the future, you may be able to return to your previous spending levels, but for now, you need to prioritize your expenses and make adjustments.
The best way to find discretionary spending you can cut is to take a hard look at your budget. Cut subscriptions you don’t use, cut back on entertainment and stop eating out. Look for bills you can stop temporarily or cancel and sign up for later when your finances improve. Think about decreasing how much you spend at restaurants, start bringing your lunch or carpool to save on gas. Also, look at what big purchases or expenses you can postpone or avoid altogether.
Once you’ve cut all you can cut, then it’s time to start making more money.
Create More Income with Side Hustles
The easiest and most straightforward way to create more income is to start a side hustle or get another job to help you with your financial emergency. There are plenty of businesses that allow you to quickly earn extra income. Finding a part-time job can be easy too. Look for local businesses that are hiring people with your skills and experience.
For example, you could apply to be a store manager, start driving for Uber or Lyft, deliver groceries through Instacart or become someone’s virtual assistant. There are a lot of side hustle jobs on online platforms like Upwork and TaskRabbit. Consider jobs and hustles where you can work from home and turn time watching Netflix into extra income during your emergency.
Think about ways to monetize the skills you already have. Most people take what they do at work and start consulting or doing it on the side. If you teach at a school, teach online. If you’re a marketer, start taking on extra clients on the side. And if you are a good writer and deeply knowledgeable about something, find some freelance writing opportunities. The possibilities are endless.
Consider getting a roommate or renting out your home for extra income. Sites like Airbnb can help you rent out part of your home temporarily for added income. Or consider moving out and staying with family and friends while renting out your entire place for even more additional income.
Before you face a financial crisis, you could take something you are passionate about and start doing it in your spare time. If you can make money doing your passion, that’s great! If your passion project starts to create more income than your 9 to 5, you may be on to your first business.
However, entrepreneurship is not for everyone and some people prefer to make passive income. Passive income is money you make without having to work for it actively. Examples include rental property income, book royalties and stock dividends.
Most passive income requires work upfront. You can’t make royalties on a book without writing the book first or start collecting rents without a rental property. But, once the initial effort is put in, you often can enjoy extra income without a lot of additional effort.
If you prefer to make passive income, invest in businesses and assets with your 9-to-5 paycheck when you are stable financially. Then, when your primary income stream is interrupted, you can use your passive income to pay for your expenses if your emergency fund is not enough.
Third Line of Defense: Borrowing from Your Investments
Building wealth through investing is a long-term financial strategy. If you invest consistently, with each paycheck, you can sit and watch your investments grow over time. However, when major unexpected expenses or a financial emergency happens, sometimes you have to make tough decisions.
If you have exhausted your emergency fund, worked as hard as you can to make more money, and it still isn’t enough, then it’s time to turn to your Investments.
Please note, borrowing from your retirement account or selling stock or other assets at a time when the market is down should be your last resort! But do what you have to do if you need the money to support your family. Don’t be ashamed to use what you have invested as your last line of defense.
Borrowing or Withdrawing from Your Retirement Account
It’s important that you consider withdrawing money from your retirement account very carefully. You may face tax penalties if you permanently withdraw money from your retirement account. The IRS can charge you a 10% penalty for your withdrawal before retirement and tax the money you take at your current tax rate.
More importantly, any money you remove from your investments won’t benefit from compound interest and the returns you earn. For example, the stock market returns, on average, about 7% each year. If you pull out $100k from your retirement account, that’s $7,000 a year in lost gains. That $7,000 would have earned another $490 every year, and that $490 would have earned more every year thereafter. Small amounts you remove today would have a huge impact on your retirement account.
Therefore, check and see if borrowing from your 401k is an option first instead of taking a permanent withdrawal. When you borrow money from your retirement account, you can set up automatic payments from future paychecks to pay the money back. Most interest rates on retirement loans are much lower than the interest rates on credit cards or payday loans. Even better, you are paying yourself the interest! The money you borrow won’t be invested and will not grow, but at least it’s guaranteed to go back into your retirement account and you avoid any penalties.
Remember, the money you cash out today won’t be there for you in the future. Everyone knows that you can take out loans to buy homes, or pay for college or cars, but you cannot borrow money for retirement. So consider this option very carefully.
Selling investments can be a way to get quick cash, but it depends on what investments you sell. For example, when selling stock, it needs to be done while the markets are open and many brokerages require a few days for the funds to settle before you can withdraw. Selling a rental property could take months, especially if the entire economy is having trouble.
Keep in mind you might be selling your stocks at a time when the market is down. This means you may not earn as much money as you could in a better market. Also, if you are selling a stock close to the time of the purchase and it has gained value, you will have to pay the higher short-term capital gains tax rate instead of the lower long-term capital gains rate. This can increase your end of the year tax bill or reduce your refund.
On the other hand, if you are selling a house, refinancing a home or opening a HELOC (home equity line of credit), it will take much longer than a few days to get your money, possibly months. Furthermore, in poor economic times or when you have lost your job or some of your income, you may not qualify to refinance your home.
Before you attempt to sell your home, consider renting it out, getting someone to take over the mortgage or house hacking. House hacking is when you rent a portion of your home to someone else for rental income, which can be done long-term or short-term with sites like Airbnb.
It’s always better to invest in a diversified portfolio during good times and have investments to rely on rather than not invest at all. You should diversify your investments so you have different ways of building wealth and minimizing risk. As the market responds to events with crashes and corrections, you will find that some assets will significantly decrease in value (like stocks) while others will maintain their worth or even increase in value (like real estate in good neighborhoods) during a financial emergency.
You Will Survive This Fincancial Emergency
Times can be stressful during a financial crisis and it may seem that things will never get better. Being prepared is the best way to survive a financial emergency, but having a solid game plan during the crisis will help you survive and sustain through it all.
Drop a comment and share techniques you’ve used recently to generate strategies to prepare yourself for unexpected expenses. Our Wealth Noir community would love to hear from you.
Acquania Escarne is the creator of The Purpose of Money, a community of women building generational wealth for their families one dollar at a time. As an entrepreneur, real estate investor, and licensed insurance agent, Acquania has always been passionate about financial literacy. On her website, Acquania blogs about ways to help you improve your money habits, create wealth, and invest in real estate. Follow Acquania on social media for daily tips.