Create An Emergency Fund For one Year: Here’s Why
Conventional wisdom tells people to save between three and six months of cash for their emergency fund in case they lose their job. That cushion isn’t as big as you think.
It doesn’t leave you much time to find the best work opportunity for you. As your cash runs out, you’ll become more desperate in your job search and take anything just to have income again.
How much money do you think you need to last a month if you were laid off today?
Do you know how much money you spent in the last year?
How much money do you think you need to live your ideal lifestyle?
How much money do you think you need to achieve financial freedom?
Know the answer to any of the above questions? If you do, where did you come up with that number?
You most likely know your annual salary figure or your take-home pay, but the number you really need to know is the cost of your current lifestyle.
Once you know the cost of your lifestyle you can more accurately estimate how much money you need to save to create an emergency fund or, as one of my professors in business school called it, “your f**k you money.”
If you are thinking about lifestyle design because you want to work on your own terms or become self-employed, I believe you need to create an emergency fund to cover a full year of all your current living expenses.
I was able to do it within a couple of years after leaving business school, and it was one of the most empowering actions I’ve ever taken.
F**k You Money
I had a professor in business school who started one of our classes by calmly telling us we needed “f**k you money.” The F-bomb definitely got the attention of the entire classroom!
He advised us to calculate how much money we spent over the last year. Not what we thought we spent, but what we actually spent.
Then he encouraged us to save one year’s worth of cash based on how we currently lived.
At some point in your life, you’ve probably heard about creating an emergency fund to cover your living expenses for at least three months in case you lose your job.
Keep in mind, however, that during the Great Recession, millions of Americans were out of work for a year or more! Yikes!
Here’s the point my professor wanted to make: You will experience a sense of financial freedom like never before when you have a year’s worth of cash behind you. It doesn’t take a million dollars to feel financially independent.
Increasing your emergency fund (or as I now like to call it my “life fund”) to one year’s worth of expenses from the conventional wisdom of 3 months will give you more work options and greater confidence.
If you find yourself in the unfortunate position of losing all your income at once, you’ll have even more time to find the best work opportunity for you.
Hands down, it was the most valuable piece of information I got from my MBA. Knowing that number can be more liberating than getting a small annual bump in your salary.
Today, my emergency fund can cover me for six years. If that sounds like a lot, consider this: I believe financial independence is defined by how many years or months you can continue to live your current lifestyle without income.
Financial Freedom Is Within Your Reach
There are different levels of financial freedom. Most of us think financial freedom is unattainable because we have confused it with being “independently wealthy” or having enough money so we never need to work again.
But the financial freedom I’m describing is very attainable. I call this stage “building your runway.”
It can be defined in three ways:
1) Saving a year’s worth of cash to meet all your expenses for your current lifestyle.
2) Saving money with the purpose of buying time and freedom to work on something you’ve always wanted to do.
3) Saving money to seamlessly transition between sources of income.
Once you have a year’s worth of cash saved up, you’ll no longer be dependent on a paycheck. You’ll gain the confidence to take more calculated risks in your career.
After I finished building my financial runway in 2008, I decided to keep extending it. Once I started working for myself, I discovered I could save even more money more quickly. I can “buy” about one year of my life back now for every year I work.
I almost feel like I’m buying myself out of servitude. I’m no longer playing catch-up. I feel in control of my destiny. I don’t need to “just be happy to have a job” even if my work is making me miserable. I now have a viable backup plan.
How to Start Building Your Runway to Financial Freedom
Assessing your current financial state is the first step toward building your financial runway. Once you understand your outflow of cash, you can start making the necessary adjustments for buying your freedom.
1) If you have any credit card debt, pay that down first.
Any kind of debt will weigh down your aspirations for financial freedom, but the worst is credit card debt. Before you start building your runway, do everything within your power to eliminate your credit card debt. I paid off mine before I put money into my emergency fund.
2) Calculate the cost of your current lifestyle.
For a quick snapshot of your annual spending habits, calculate the total amount of money that left your checking account over the last year. Add up all the debits from your checks, automatic withdrawals, debit card transactions and cash withdrawals. (To make this even easier, just download our free lifestyle calculator.)
3) Identify expenses you can reduce or eliminate.
As you diagnose your current financial state, look for ways to reduce your spending. Cut spending on your highest monthly bills and the money you spend on your worst vices (think alcohol, buying clothes or eating out). Use the extra money you save to build your runway.
4) Calculate your average monthly, weekly and daily spending.
Now determine the average cost of your lifestyle on a monthly, weekly and daily basis. Use these numbers to compare against discretionary purchases you might want to make.
For example, the cost of my current lifestyle is approximately $175/day. I could buy an iPad for around $500 or I could buy another three days of freedom.
That’s seriously how I think about spending my hard-earned money!
5) Get support if you can.
When you’re making any kind of big change in your life, you are much more likely to stick to your new set of habits when you have support. Find and hang out with others who also want to build their own financial runway.
Building your runway is saving with purpose. Your primary purpose is to buy time and freedom.
Don’t build your “emergency fund” with the mindset of preparing for the worst. See it as your first step toward financial independence and a symbol of your growing wealth.
You might even think of your financial runway as the allotted time you’ll need to transition from one income source to another. The length of your runway depends on your level of risk, current lifestyle costs, responsibilities and the ramp-up time needed for your next income source to take hold.
Your financial freedom is close at hand! You can achieve it!
Calculate the Cost of Your Ideal Lifestyle
How much money do you think you need to make every year to live your ideal lifestyle? Download our free Lifestyle Calculator now to find out!
Once you know how much money you really need to make every year, you’ll know exactly how much money you’ll need to build your financial runway.
