*I know I’ve been slacking on Financial Fridays. I promise we’ll get back to them, but things have gotten so bogged up around here, I haven’t had the time. I’m sure all seven of my regular readers are disappointed.*
Alright, so I know I’ve been preaching to you through this blog about developing an emergency fund, and how you only really need $500. That’s not exactly the truth. I mean, it is for dire scenarios. If you can build an emergency fund greater than $500, you’ll be in much better shape, but if you are barely scraping things together, $500 should be your absolute minimum.
I’m going to lay out the different levels of emergency funds here for you, so you can know how to build your emergency fund. I encourage you to develop through these levels as you gain more financial independence, because they will help you be better prepared. Let’s take a look:
Bare Necessities – $500
This is the bare bones version of an emergency fund, and I strongly encourage every person living in America to have at least $500 in savings at all times. This type of money will not cover you in the event of a job loss or help you pay off debt. This is the absolute bare necessities of an emergency budget. If you can only manage this amount, though, you’ll be better off than millions of Americans.
Having a small amount of money in savings for emergencies will prevent you from going into debt further, and will help you for some emergency scenarios – particularly medical expenses, car troubles, or unexpected bills. However, as soon as you can increase the amount you’re saving, you should take the next step up.
Level 1 – 1 Month of Expenses in Savings
The first tier of true emergency savings is 1 month of your living expenses in savings. I’m differentiating this a bit from the next level, because this is only 1 month of your bills, such as rent, insurance, credit card bills, etc. Once again, this is still not an ideal scenario, but it will be useful.
Having 1 month of your necessary expenses in savings will make sure all of your bills are current if you lose your job or there is some major catastrophe. It is just additional insurance against debt, and you can leverage it for bigger expenses as you get more financially secure.
Level 2 – 1 Month of Salary in Savings
This is the next step, and is the basis for a safety net. You should have enough in savings so that, at the very least, if you lost your job, you could replace your salary for the following month without interruption. If you do this, you’ll be able to keep up your lifestyle while looking for another job or getting through the major disruption in your life or income.
Additionally, if things get really dire, and you have created your budget following the 50/30/20 rule, you can use this month of salary to cover 2 months of necessary expenses. As you can see, we’re spreading the timeline of financial security a bit longer each time.
Level 3 – 3 Months of Salary in Savings
The minimum recommendation from the majority of financial advisers is to have at least 3 months of salary in savings. This is not always feasible, and most Americans have clearly not achieved this level, especially since many are struggling to even have $500 in savings. Three months of salary saved up will go a long way towards solvency, and most people who have that much in savings are stable enough that they don’t need to worry about their finances in the event of an emergency.
To me, this is the baseline of emergency budget success. You should start out with each of the previous steps, but this should be your absolute minimum goal. It may take you 2 or 3 years to get this amount in savings, and that’s okay. Keep pressing forward and you’ll get to a point where you won’t have to worry when there is a major financial disruption in your life.
Level 4 – 6 Months of Salary in Savings
Having 6 months of salary in savings will pad you even further against losing your income, and it’s the point where you can begin to leverage your savings for your benefit. Because you have 6 full months of salary waiting around, you don’t need to have it all liquid at once. You can take 3 or 4 months worth of salary and invest it in stocks or real estate and still be secure because you have liquid capital for the first few months in case there is a major issue.
When you have 6 months of salary in savings, you are farther along the path to financial independence than a lot of Americans, and you can start to make your money work for you. Having this level will help you build wealth and start to leave your financial worries behind.
Level 5 – 12 Months of Salary in Savings
Alright – the pinnacle, the peak, of emergency savings. Having 1 full year of salary stashed away in case of emergency. This is a lofty goal and a hefty sum. It can be pretty difficult to just throw down an entire year of your earnings and keep it in a bank instead of using it for your expenses, but this is the goal.
If you are able to put aside 20% of your salary every year like the 50/30/20 plan stipulates, you can achieve this goal in 5 years of less (depending on interest and how you save or invest your money).
With a full year of salary available to you, you should be at the point of real financial freedom. You could transition jobs by choice if you wanted, or use a portion of the money for a large investment stream. You could even consider starting your own business, if you needed to go without a salary for a long period of time.
Life Hack – Passive Income Streams/Side Hustles
Here’s where things get interesting: if you want to hack this process, you can reduce the savings you need by increasing the amount of “incorruptible income” you have. Incorruptible income is a term I just now came up with, but it’s essentially income streams that are more difficult to lose than a job.
With traditional, earned income, your income is dependent on the market and the whims of your employers, which can change at any moment. With a passive income stream or a side hustle, you are less likely to lose that income because of your control over it. Because of this, you won’t need to have as much money in savings in case of emergency, because your earnings can continue. On the flip side, however, you’ll also be earning more in the meantime, and can therefore put more towards savings.
With a side hustle or passive income stream, you can develop your savings up extremely quickly, and then rely on the income stream to carry you in the event of an emergency, preventing any financial disruption in your life.
Seriously, start saving. But just as important, start developing a side hustle. If you can create an income stream that no one can take away from you, particularly a passive one that needs little maintenance, you will be in a great position if there is an emergency. That 1 month of expenses may turn into 2 or 3 because you don’t have to rely on the savings exclusively.
If you can increase your earnings, you can build up your savings quickly, and then that savings can be leveraged to create additional income for you and protect you from financial instability, no matter the cause. Seriously, start saving and start hustling.