“Once upon a time there were three little pigs. One pig built a house of straw while the second pig built his house with sticks. They built their houses very quickly and then sang and danced all day because they were lazy. The third little pig worked hard all day and built his house with bricks…”
We all know the outcome of this classic short story.
Is your financial plan being built out of straw, sticks or bricks? Are you taking your time to make sure you have a solid foundation in place?
Building a sound financial future takes patience and requires that a foundation be put in place. A good financial planner will work with you to develop a plan that ensures you have all the right building blocks in place. Unfortunately, many financial planners are not compensated in a way that encourages them to focus on building blocks that are not tied to investments and insurance. Therefore, these critical steps can often get overlooked. The result? A financial plan that is built on straw or sticks that may not be well thought out and is vulnerable to external factors such as the curveballs life will inevitably throw your way.
In this two-part series, I will give you four take-aways (“building blocks”) that you can start working on today. These four building blocks will serve as the foundation for the rest of your financial plan.
Building Block #1 – Establishing an emergency fund
Talking about saving for retirement and daydreaming about the future is fun. Making sure you have a good emergency fund in place is certainly not as fun to think about. Nonetheless, it is a critical piece of the puzzle.
Why does having an emergency fund matter? It gives you peace of mind that an emergency resulting in a significant unexpected expense isn’t going to blow up and derail the rest of your financial plan. Specifically, it gives you peace of mind knowing you won’t have to borrow from retirement or take on additional debt to cover this expense. According to the 2015 Bankrate Consumer Survey, 30 million Americans (13%) tapped into retirement savings to cover an unexpected expense (aka “emergency”). Certainly not ideal considering that in most cases, this comes with taxes and a penalty for early-withdrawals.
What should an emergency fund look like? A good rule of thumb is saving up 3-6 months of expenses (not income) in a place that is readily accessible (and separate from your other account where expenses are made) such as a simple savings account or money market savings account.
Don’t get too excited about the annual percentage yield (aka how much interest you will earn per year) on a simple savings or money market account. A quick search online at the time of this post showed savings accounts having rates hovering around 1% and money market savings accounts around 0.75-1%. If you are looking for an account, you can go to Bankrate to search for the best rates. You should also check with the bank you are already using to see if their rates are competitive. Save any excitement for returns to your retirement savings. The goal here is just security and protecting your financial plan.
There are four questions I commonly receive about emergency funds.
Q: You say an emergency fund should be made up of 3-6 months of expenses. Which should I do? 3 months? 6 months? Somewhere in-between?
A: Two main factors that impact this decision include your money personality and your ability to get extra cash in the event of an emergency and/or losing your job. First, and most importantly, what is your personality when it comes to money? Can you sleep better at night knowing you have an extra cushion in the event of an emergency? Where applicable, make sure to take your spouse’s personality into account when making this decision. I always suggest that if one partner wants to be more conservative (6 months of savings) and the other more aggressive (only 3 months), it is best to err on the side of 6 months. The second major factor has to do with your ability to get extra cash quickly in the event of an emergency. For example, in the event of a major health crisis or a job loss, can you or your spouse pick up some extra money through working extra shifts to avoid having to borrow to cover the expense? If yes, maybe you err towards the 3-month end of savings.
Q: I don’t have anything saved up for an emergency fund. How do I practically build one up?
A: Make this a budget item to pay yourself first rather than trying to scrape up what is left afterwards. Obviously you want to build this up as fast as you possibly can but if you are several thousand dollars off, determine what that difference is and make a plan to save some each month over the next year or two to catch-up. For example, if you determine that you need $15,000 in your emergency fund and have only $1,000 saved to date, take the difference and divide it by 24 to achieve this goal in two years. The result would be saving $583 per month for 24 months to have a fully funded emergency fund.
Q: How should I handle an emergency fund as a student or resident?
A: If you are a student or resident with limited income and don’t have any money saved up for an emergency, get a small fund started (e.g., $500-$1,000) to avoid having to take on any additional debt in the event of an emergency. Then, once you have finished school and/or residency, re-evaluate in the context of the question below. Make a commitment to have this ‘starter’ emergency fund built up within the next 3 months.
Q: How do I balance the importance of having an emergency fund versus paying off high interest rate debt?
A: If you have a plan in place to pay off your debt in a short period of time (e.g., 12-18 months), I think you can get away with a small emergency fund (e.g., 1 month of expenses) with the commitment that you will build that up further after you have your debt paid off. If you are going to be paying off debt for much longer than 12-18 months, I recommend you build up a full emergency fund while paying minimum on all debt payments. Then, after that emergency fund is built up, go ahead and move forward with paying extra on your debt to minimize the amount of interest you will pay on that loan over time.
Building Block #2 – Setting a budget
Budgeting isn’t fun by any stretch of the imagination and certainly comes easier to some than others. My wife, Jess, wrote a killer blog post on budgeting last week. The budget was the hardest and most important piece of the puzzle for us when we were paying off $200,000 of non-mortgage debt.
I am a firm believer that everyone should have a budget. Yes, even those that have no debt and are on track to achieve other financial goals. The budget categories and size of the box you are working within may change as time goes on, but regardless, the budget is still in place. Why? A budget is a refection of your financial goals. It puts purpose to your spending and it is important to be intentional about your spending whether you are $200,000 in debt or a multi-millionaire.
There are six simple steps to putting together a budget:
First, assign a budget amount to all of your ‘essential’ expenses (e.g., housing, transportation, groceries, giving).
Second, assign a budget amount to discretionary categories (e.g., eating out, vacation, coffee trips, etc.)
Third, determine how much take-home pay is remaining after the first two steps to put towards other goals (e.g., paying off debt faster, saving for retirement, buying a home, etc.)
Fourth, if the amount remaining in the third step isn’t enough to allow you to meet those goals, go back to the discretionary areas in step two and make some cuts. This is where the magic happens! Believe it or not, for Jess and I, we were able to free up over $2,000 per month (approximately 30% of our take-home pay) by getting serious about this step.
Fifth, determine how you will track your expenses and progress along the way. Whether it is paper and pencil, Excel or some fancy web-based software, the method is less important than the reality of making sure the tracking is happening. We used the free version of an online tool (www.mvelopes.com). This is an excellent tool that takes the envelope-based system but implements it electronically. There are several free online tools out there (Mint, EveryDollar) and you can use what works best for you and your family.
Sixth, update this each month. Jess and I have found the budget to be most effective when we use the previous month as a guide and make small updates to ensure we are accounting for expenses that are unique to the upcoming month (e.g., birthday gifts, hosting of family/friends, etc.) This helps to avoid frustration with overspending categories and having the desire to bail on the budget all together.
If you are looking for a place to get started, here is a budget template that will walk you through the process of categorizing all your expenses.
In a recent blog post, “Stop Wishing and Start Planning,” I made the case that for most pharmacists; it should be well within their means to save 15% of their income towards retirement while living a reasonable lifestyle. As part of that article, I provided an example budget for a pharmacist. Check it out if you are looking for a place to start with determining how much money should be categorized to various expense areas.
Your Financial Homework: Do you have an emergency fund in place? How about a budget? By the end of this month, make a commitment to have a budget in place that includes a line item for funding your emergency fund.
As always, if you found this information helpful, please share with your friends and colleagues. You can also follow me on Facebook (www.facebook.com/yourfinancialpharmacist) and Twitter (@FinancialRPh).