Level 1 of Financial Freedom

August 1, 2023

I’ve asked hundreds of clients and prospective clients the question, “What is important about money to you?”

And overwhelmingly the number #1 answer is some version of peace of mind.

But 49% of Americans can't cover a $400 emergency.

49% of Americans are one bad day away from serious financial issues.

No wonder we lack peace of mind.

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Once you have a funded emergency fund, you have a version of financial freedom.

But without an emergency fund?

The unexpected expenses can turn into financial destruction.

If you can’t handle a $400 emergency, you may have to take on credit card debt, and then you have to find a way to pay off this new bill on top of your existing bills.

And before you know it you’re in a vicious cycle of credit card debt and find it increasingly impossible to find your way out.

There are levels to financial freedom.

And an emergency fund is level 1.

Before we figure out how much you need in an emergency fund, let’s clarify what an emergency fund is for.

It is for things like:

  • Car breaking down
  • Furnace going out
  • Losing your job

It is not for:

  • Upgrading your phone
  • Replacing carpet floors with wood
  • Vacation

Don’t treat your emergency fund just like another savings account.

If you do, it won’t be there when you need it.

So how do you decide how much you need in your emergency fund?

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Step 1:

Calculate what you need to survive.

These are the expenses that will never go away: even if you lose your job, even if you really wish they could:

  • Food
  • Utilities
  • Rent/mortgage
  • Childcare
  • Debt

Once you’ve figured out these expenses, add them up (you’ll need it for step 2).

Step 2:

Next, you’re going to determine how many months you want to save.

The rule of thumb is 3-6 months.

The number of months you save for isn’t just a matter of preference, it also depends on your circumstances and who is relying on you for money.

The person who chooses to save for 3 months may look like this:

Luis just graduated college, lives in a big city where he doesn’t have to own a car, he rents his apartment, he is single with no children and no pets, lives near his family who would be there to support him, and has an in demand and stable job.

The person who saves for 6 + months may look like this:

Anna is the sole-income provider for her family, she is married with 3 children and 1 dog, she owns a newer car but an older home, and her job is relatively stable but she's think about switching careers.

Start with 3 months and add more months if you:

  • Are the sole income earner
  • Have dependents
  • Own a house
  • Own an older car
  • Have an unstable job

Step 3:

Now, that you’ve decided your expenses and the months you want to save for it’s a very simple calculation:

Monthly Expenses x # of Months = Emergency Fund

Now where do we keep this account?

Step 4:

Somewhere separate from your checking, other savings accounts, and investment accounts.

Open a new account and designate it for emergencies only.

This separate account helps build a “hands off” mindset.

I find a lot of people obsess over the best account for their emergency fund.

The truth is, financial freedom is about getting the big things right and obsessing over the best interest rate for your emergency fund is not one of the big things.

Find a High Yield Savings Account, fund the emergency fund, and move on with your steps.

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But it is important to keep your emergency fund in cash and not invest it.

Why?

Because emergencies tend to coincide with other emergencies.

You're most likely to lose your job while the stock market is trending downward.

And if your $30,000 emergency fund is invested and we hit a recession, it won’t be a $30,000 emergency fund anymore.

You need to be able to rely on the amount you have saved for yourself.

One of my biggest mistakes as a beginner investor was skipping over this foundation and jumping right into investing.

Investing, to me, was way more exciting and felt like I was getting to freedom faster.

But in the years that followed I:

  • Hit a deer with my car (that’s Michigan for you)
  • Watched my dog tear his ACL (or the dog-version of an ACL)
  • Had to pay out of pocket for expensive MRIs

After my dog tore his ACL, I realized the importance of an emergency fund and vowed to always keep it funded.

I still remember the drive back home after hitting the deer and thinking, "this sucks, but I can cover it."

An emergency fund will take an unexpected expense from a financial burden to a minor inconvenience.

Which is why Step #1 of my financial freedom path is to build a small emergency fund.

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