The most important financial New Year's resolution you can make
Many Americans make New Year's resolutions, and they often have to do with financial goals. Some are rather vague, such as "save more money," while others are very specific, like "save $1,000 in an IRA" or "pay off $2,000 in credit card debt."
Whatever your financial New Year's resolution may be for 2018, there's one step that's even more important to take: establishing and building up your emergency savings.
Why an emergency fund is so important
Simply put, unexpected expenses happen more often than we like to think, and many people are ill prepared to deal with them. Sixty-three percent of Americans say they experienced a "financial setback" in 2017, according to the National Endowment for Financial Education. Also, according to a Federal Reserve report, half of Americans can't handle a $400 expense without borrowing the money or selling something.
Here's the point: Let's say that your New Year's resolution is to pay off $1,000 in credit card debt. Then, in January, your car breaks down and needs $500 in repairs. Since you don't have any emergency savings, your $1,000 in credit card debt quickly becomes $1,500, making your resolution far less achievable. On the other hand, if you had some money stashed aside for situations like that, you could continue to pay off your credit card as planned.
As a personal example, early in 2017, lightning struck a tree in my backyard. It was damaged in a way that immediately threatened our house, so having the tree removed as soon as possible was absolutely necessary. Fortunately, we were able to have a tree service deal with it before it fell, but the bill was over $700. Thanks to having emergency savings, we didn't have to put it on a credit card, nor did we have to alter our retirement savings contributions in order to cover it.
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How much do you need?
The "industry standard" recommendation among personal finance experts seems to be six months' worth of expenses. If this seems like a large amount of money, you're probably right. This means that ideally, you should aim to save six months' worth of:
- Mortgage or rent payments
- Insurance payments (Car, home, life, etc.)
- Utility payments
- Car loan payments
- Other recurring expenses (pest control, alarm system, etc.)
- Debt payments (such as credit cards)
- Routine vehicle maintenance
Of course, the six-month target isn't ideal for everyone. Your ideal emergency savings needs could be higher or lower. For example, if you and your spouse both have stable jobs and little debt, a three-month emergency fund could be more than sufficient. On the other hand, if you are the sole earner in your household and/or don't have a stable employment situation, more than six months' worth of expenses may be a smart idea.
You don't need to get there overnight
Even a three-month emergency fund may seem impossible if you're starting from zero, but don't give up. You don't need to get there overnight, or even quickly. My wife and I built up our emergency savings for years before we felt like we had enough.
The good news is that an emergency fund of $1,000 should put you in a position to handle most unexpected expenses, so this could be an attainable goal for 2018. If this sounds too aggressive, aim for $500, which would put you in a better position than about half of Americans, according to that Federal Reserve data.
How to make it happen
If you don't have much emergency savings yet, the smartest financial New Year's resolution you can make is to start, or add to, your emergency fund. My suggestion is to come up with a specific goal for the year ($1,000, $500, or some other number) and divide it by the number of times you get paid in 2018. (Note: If you get paid every two weeks, this is 26.)
For example, let's say that you want to save $500 and you get paid twice per month, or 24 times per year. This means that if you set aside just $21 out of every paycheck, you'll hit your emergency savings target by the end of 2018.
We all hope that the unexpected doesn't happen, but the reality is that flat tires, veterinarian bills, and trees leaning toward your house can and do happen, so it's best to be prepared. Furthermore, a solid emergency fund will put you in a better position to achieve your other, more exciting, financial goals.