Expect the unexpected. That might be from a car commercial, it might also be the single most important piece of advice you can drill into the malleable minds of a young adult, fresh off the adolescent conveyor belt.
Without getting too sciencey on you, the Universe is hellbent on causing as much chaos as possible. It’s called entropy and more commonly known as the Second Law of Thermodynamics which states that in a closed system if no energy enters or leaves the system, the potential energy of the state will always be less than that of the initial state.
In other words, things eventually fall into disorder. Why bring physics into a personal finance blog post? Because “it defines the fate of the universe and the ultimate purpose of life, mind, and human striving: to deploy energy and knowledge to fight back the tide of entropy and carve out refuges of beneficial order,” (Stephen Pinker, Enlightenment Now, 2018).
Creating order in our lives is hard. A guy named Murphy once said, “what can go wrong, will go wrong.” He could have easily said “water is wet” and saved us all from the obvious. Statistically speaking, there are so many (many, many) more ways things can go wrong than go right. To carve out our “refuges of beneficial order” we have to extend vast amounts of time, energy, and resources to make it happen.
To think, or even expect, that our little lives will go to plan is both silly and naive. This is exactly why you need a Rainy Day Fund (I like to call it an Entropy Fund but my nomenclature hasn’t caught on).
The purpose of a Rainy Day Fund is to give yourself a buffer for when the unexpected happens and suddenly there is a lot more chaos in your life. A damaged roof. A car accident. A layoff. Your Rainy Day Fund is the first to receive the blow and protect your assets and long-term savings. And guess what, we aren’t really good at managing our Rainy Day Fund (or having one altogether). Only 39% of Americans today could afford a $1,000 emergency medical bill (CNBC).
This needs a fixen.
How Much of a Rainy Day Fund is Enough?
Before diving into how to save for a Rainy Day Fund, the question on your mind is: how much is enough? A quick Google search will bombard you with experts recommending “3 to 6 months worth” of living expenses saved up in your Rainy Day Fund. While this is generally a good rule of thumb to follow, it doesn’t take into account the variety of factors that make up your lifestyle (family size, medical history, job security, etc.).
Typically, not having enough of a Rainy Day Fund is the main issue with most folks, but there are situations where having too much is also not a great idea. Especially, when you are paying down debt or missing out on higher interest-bearing accounts.
That’s why I advocate for the Goldilocks Approach.
Just like the fable, the goal is to have just enough but not too much in your Rainy Day Fund. While having enough money stashed away in an easily accessible account is vital, having too much means you’re missing out on investing said funds in higher yield accounts elsewhere (or paying down high-interest rate debts). So how much is enough?
To arrive at this amount, we’ll take a step-by-step approach.
Dave Ramsey recommends starting with a $1,000 Rainy Day Fund, especially if you are aggressively paying down debt. This should help cover minor inconvenience emergencies like getting your car towed or paying a pet medical bill. $1,000 is a nice chunk of change to give you some peace of mind but it’s not enough.
This is why we move onto step two. Instead of settling for an arbitrary number, start by looking at all the “exposed” areas of your life. Do you have a high deductible health insurance plan? If so, how much would you have to shell out in an emergency? If you own a home, what’s the most expensive repair not covered by insurance (appliances, storm damage, etc.)? If you lose your job, how soon are you likely to find a new one?
Keep asking yourself these questions and aim to save enough to cover the most expensive of these exposed areas.
And now we’ve moved on to step three: one year’s worth of savings. This is a big amount and something you can hopefully achieve after a lengthy commitment to saving. Which is exactly the point: commitment. After paying down your debts and saving in long-term savings accounts, tuck away a little bit more into your Rainy Day Fund. If you save 10% of your monthly spending it’ll take you, on average, about 10 years to hit this level.
Yes, that’s a long time. But the point here is to arrive at a place where you’ll have a year’s worth of cash available if anything happens to you and your family. Don’t worry if this sounds like a daunting task, take it one step at a time.
Where to Keep Your Rainy Day Fund
The most important thing to remember is that this Rainy Day Fund needs to be separate from your other savings so it can’t get mixed up with them.
What I mean is the cash should be liquid, however, out of sight. If your financial institution offers bundled checking and savings accounts, it might seem like an obvious choice to tuck away your emergency fund in a very visible savings account. But don’t fall for this temptation.
Because this Rainy Day Fund is intended to be used in worst-case situations (i.e. not all too often, hopefully), you might as well make the money still work for you in the meantime. If you look around, there are many other institutions that offer high-interest-bearing savings accounts. They aren’t necessarily banks, per se, that offer measly points of a percentage in return for keeping your money with them. Instead, there are many new institutions that are internet-centric and keep their costs low, thus passing along higher savings to you the customer.
Another option, albeit an unpopular one, is to put your Rainy Day Fund in an FDIC-insured CD account. A CD, or certificate of deposit, is issued by a bank. The benefit of these accounts is their high interest rates, which can be as much as five times more than the average interest rate for savings and checking accounts. They also come with FDIC insurance, meaning if something were to happen to your bank or institution, you would be reimbursed up to $250,000 per account ownership type (individual/joint).
The downside? You’re not allowed any withdrawals until after the CD has matured — typically anywhere from three months on up. And while it might seem like an inconvenience now, the penalty for early withdrawal is probably more preferable to the interest you might incur putting your emergency expense on a credit card or personal loan.
Either case, keep your Rainy Day Fund liquid but away from all your other accounts to avoid the temptation of pinching a little bit here and there.
Automate Your Rainy Day Fund
Besides asking “How much is enough?” you might also be asking “How do I start saving?”
Personally, I like to be aggressive with my financial goals. When I wanted to get me and my family out of debt, we went after that goal with literally everything we had. In 16 months we paid off over $33,000 worth of debt. I’ve applied the same mindset to saving.
Now when we receive our bi-weekly paycheck, I set aside just enough to cover two week’s worth of living expenses and put the rest away in our Rainy Day Fund. This has allowed us to save over 20% of each paycheck and grow our Rainy Day Fund quicker than expected.
However, I know not everyone is in the same situation as me, nor does everyone budget every single dollar that they own (although I recommend you should). Therefore, the next best thing you can do is automate your savings by setting up an automatic transfer from your paycheck to a separate savings account. That way, you don’t even have to think about it or worry that maybe this time you should spend the money on something fun instead.
As a guy named Ronco once said: Set it and forget it!
Don’t Let Entropy be Your Enemy
Entropy will happen, there’s no getting around that. However, your finances don’t have to suffer the same consequences. From sudden illnesses to natural disasters, it’s important that you have a Rainy Day Fund in place so that when an emergency strikes you’re ready for anything.
This is original content from NewsBreak’s Creator Program. Join today to publish and share your own content.