How to Build a Financial Safety Net Before Life Changes Happen

There’s a lot of noise in the world of personal finance. If there’s one thing that I need you to understand, it’s this: the MOST IMPORTANT piece for ensuring your financial security is having an adequate emergency fund. It’s your safety net; it’s the rock upon which you stand when things get uncertain and shaky.

But how do you balance having an adequate emergency fund while making sure that you’re not leaving too much money on the table? Well, let’s talk through the steps that you’d take if you wanted to develop an emergency fund but not overfund it.

Step 1. Figure out how much you spent over the past 12 months.

If you pay off your credit card in full each month, pull a spreadsheet of every transaction from the past 12 months from each of your checking accounts.

If you don’t pay off your credit card in full each month, pull transactions from both your checking account and credit card(s).

Sum every expense, but be sure to exclude expenses that you know won’t be going forward (like down payments for a home purchase, new car purchase, wedding expenses, etc.). We just want to know what you would reasonably expect to spend in a year.

I offer to do this as the first step in the financial planning process with most of my clients. Over the years, I’ve found that we usually believe that we spend significantly less than we actually do. It can help a lot to have a trained third party take a look at how money is moving in our lives. And, to be clear, I never tell people how I think they should be spending their money. I’m only interested in the raw numbers.

Top tip: Keep unexpected one-time expenses like hiring a plumber for a water leak or mechanic work on a car within the analysis. This provides you with a little extra breathing room, and it’s better to overstate expenses here rather than understate.

Step 2. Find an average monthly expense amount.

We all know that certain months have higher expenses than others, so my advice is to figure out an average. That average will capture months with bigger expenses and months with smaller expenses.

Once you know what you spent in total over the past twelve months, find the average by dividing that total by twelve. We’ll use this number as our “monthly expense” figure for the purposes of calculating your emergency fund.

Step 3. Determine how much of an emergency fund you want in multiples of average monthly expenses.

There are very few “rules” in personal finance (don’t get me started about people who try to push rules as advice), but in my experiences working with clients as a financial planner I’ve found anywhere from 3 to 12 months’ worth of expenses in savings helps provide adequate peace of mind.

How do you decide what level is right for you? It depends on your particular circumstances. Are you single with a job that’s in fairly low demand and you can’t really count on parents or other family members to support you? I’d recommend aiming towards the 12-month range. Are you in a committed relationship with a partner who has a solid job, do you have a job that’s in incredibly high demand, or do you have family members who could bail you out if things get messy? You can run a little bit closer to the 3-month number.

Top tip: If your safety net plan involves asking anyone else for help (like a partner or family member), I can’t stress enough how important it is for you to have a conversation with them before the stuff hits the fan to understand exactly how and under what circumstances they’d be comfortable supporting you.

Step 4. Open a high-yield savings account.

This is part of how we help make sure this money keeps working for you.

If you have a savings account at a brick-and-mortar bank that you could walk into and withdraw money from, you’re probably missing out on money. Traditional banks typically offer less than 1% on deposits in their savings accounts.

Many online banks, on the other hand, are offering over 3.5% interest on deposits at the time of this writing. This means that your money is making more money while it sits waiting for you to need it.

There are loads of high-yield savings (HYS) account options. Poke around and find one that works for you. Just be aware that you want to look for an account that’s FDIC insured.

Step 5. Develop a strategy for right-sizing the amount in your savings.

Now that you know how much you need to have in your savings, do you have too much, or too little?

Too much

This is a pretty good problem to have. Your next step is to decide how you want to invest the excess. That’s something that a financial planner can really help out with.

Top tip: If you’re not already maxing out the contributions to your employer-sponsored retirement plan, there may be a way to get that excess money invested AND save yourself some money on your taxes.

Too little

This is tougher, but certainly not impossible.

For almost anyone who doesn’t have an emergency fund, I would strongly recommend doing whatever you can to at least build up one month of expenses in a high-yield savings account. This might mean making just the minimum payment on credit cards for a few months, reducing/stopping contributions to your employer-sponsored plan briefly, or even going on a temporary forbearance on student loan payments. Everyone finds themselves in situations where they have an unexpected expense. Having at least a month’s worth of expenses saved up gives you that touch of breathing room you need to keep you from going into more debt, or maybe even into debt in the first place.

Once you have at least a month of expenses saved up, going back to making your regular payments is back on the table. It’s important, though, to keep finding space in your monthly cash flow to put money into that HYS account. Keep in mind, even small amounts add up.

Top tip: If you have an emergency and don’t have an adequate emergency fund, a loan on your employer-sponsored plan might be an option. This has significant disadvantages, but may be a better option than going into credit card debt.

Conclusion

I’m not going to sit here and pretend that building an emergency fund is an easy process—it’s not. It’s also not easy for some people to overcome the psychological barrier where they think they need to have copious amounts of money on hand.

If you want some help with this process from someone who understands the emotional challenges as well as the financial realities, let’s have a conversation.

John Howe-Wemett, CFP®, AEP®, MSFP