So you’ve gotten your debt repayment plan together and you’re demolishing your liabilities. First of all, sit back and give yourself a pat on the back. You’ve taken the first steps towards Getting Rich Young, and you should be proud of yourself. If you are wondering what the next step is, then you’ve come to the right place.

I know that it takes a lot of hard work to get out of debt and you do not want to risk having to fall back into the hole for an emergency that is outside of your control. A job loss, a surprise medical bill, or an auto accident are all real possibilities. The best way to prepare for something that is uncertain, is to pull together an Emergency Fund (also known as a SHTF Fund or FU Money around the web). Even if you’re not completely out of debt, it still makes sense to start building up an emergency fund in order to prevent yourself from having to take out last minute high interest debt on a credit card.

The Year of Surprise Bills

Over the last few years, I had the typical car from hell. The car was almost 20 years old and was starting to fall apart. It felt like every week there was something new going wrong with it. I tried learning as much as I could about cars and doing as much as I could on my own and with friends help. However, those mechanic bills just started to pile up. Finally, I had to just say screw it and got rid of the car. My wife and I are down to one vehicle right now, and although it’s inconvenient at times, we’re getting by just fine and saving a bunch of money because of it.

In the same year that we got rid of the car, we also had quite a few surprise medical bills. Sliced hands requiring stitches and gall stones requiring surgery both happening in the same year. All together this added up to $1,943.25 in out of pocket expenses.

If I had not planned ahead and had an emergency fund/SHTF fund/FU fund or whatever else you want to call it, those few years could have been rough to get through. Having a reserve of cash ready to go for unexpected expenses was exactly what I needed. This is especially important for people who are just starting out and don’t have many assets that they can call upon in a pinch.

Building an Emergency Fund

So how do you go about building an emergency fund? You know that extra money that you have coming in from destroying your debts? Take those extra payments (or some of them if you still have some outstanding loans) and start building your fund in a dedicated checking or savings account. The key is to separate this money out from your other accounts. This is not vacation money. This is not money for presents. This is not money to spend on a new boat. This money is for emergencies only. Hopefully, you will never need to touch it. However, it will be there for that day when something big happens and you are unable to pay by other means. You should always try to pay for emergencies by other means first, but draw down from your emergency fund before taking on new debt.

There is a lot of debate around the web about how much an emergency fund should contain, but common numbers range between one month and one year of expenses. Typically I suggest between three and six months. I would recommend that you base your number on a couple of factors.

1. How much does passive income cover your expenses?

Passive income is never truly passive, but let’s say mostly passive income. We will define passive income as money that you earn that is not a direct trade for your time. Some examples include dividend income, interest income, and business income. If your business income requires you to be the one managing the day-to-day operations to earn money, then this is not passive. You may own a business, but that business also owns you. If you fall ill and can’t go into work for a few months, would you still get a check and not have to worry? The more that passive income covers your expenses, the less you need an emergency fund and the more you can skew towards three months.

2. How many sources of income do you have coming in?

If your only source of income is a job, then you should shift closer to six months. How senior are you in your company? It can take higher level employees far longer to find a new job than a more junior employee. If you are an executive, you may want to have an emergency fund of closer to a year or more. If you lose your job, you do not want to have worry about making ends meet while you try to find a new job. You also don’t want to be rushed into settling for a job just to keep the lights on either.

3. Do you have an less liquid assets that you can draw down from without penalties?

It is never recommended to gut your retirement accounts, but in a pinch they can be used for an emergency. You should still have an emergency fund, but if you have a large nest egg built up, then you may be able shift closer to the three month mark with your emergency fund. Keep in mind that you should not include any tax advantaged accounts in this number that may incur fees. That means no gutting your 401K or Traditional IRA.

What’s the Point?

Think of your emergency fund as a form of insurance. Except instead of being specific to one financial hardship, it can cover whatever financial hardship comes up. However, instead of paying premiums to somebody else every month and hoping that they actually cover you when the time comes, you are insuring yourself. The Emergency Fund is often ignored but please do not disregard this important foundation for financial success.

Thank You!

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How has an Emergency Fund benefited you?