How To Build Your Emergency Fund

In this article, I would like to delve deeper and go through the steps to take to actually start building your emergency fund. I’m going to layout a simple 5 step process that helped me establish my emergency fund; if I can do it, trust me you can as well!

Step 1: Decide your goal

First things first, you need to quantify what your emergency fund will be i.e. what your financial goal is. Setting financial goals is one of the key concepts of personal finance, we must know our destination in order to find the most effective path to get there. You wouldn’t go on holiday without having a destination after all.

“People with goals succeed because they know where they’re going.” – Earl Nightingale

So, how do you determine this goal? This was the issue that trumped me the most when I initially wanted to build my emergency fund – people kept advising me to save between 3 to 6 months’ worth but how was I going to pick an exact size? All the advice out there is so vague!

So I did some research and I came up with a framework that helped me figure out the exact size of my emergency fund. This framework consists of 4 simple questions to ask yourself (remember to note down the number corresponding to your answer in each question):

How difficult would it be for you to replace your existing income?
1. Very difficult – I don’t have any access to alternative sources of income

1. Difficult

2. Average

3. Easy

4. Extremely easy – I have multiple alternative sources of income

How secure do you think your current job is?
1. Probably about to get fired

1. Never really secure, there’s a high turnover rate

2. Relatively Secure

3. Quite secure

4. Extremely secure

In your profession/industry, how skilled are you?
1. Entry level

1. Proficient

2. Advanced

3. Expert

4. Industry leader

How happy are you in your current job?
1. I despise it

1. I’m miserable

2. Content

3. Love it

4. Couldn’t be happier!

Done? Add up the numbers that correspond to your answers and see where you fall in the range below:

Score

Emergency Fund Size

4 – 8

6 months

9 – 13

5 months

14 – 18

4 months

18 – 20

3 months

Once you’ve added up your numbers and determined your emergency fund size, multiply your monthly income by the number of months and there you have it, you have just made your emergency fund goal!

So as a quick example, if after answering the 4 questions above, I get a score of 13, it means I should aim for an emergency fund size of 5 months. Let’s say my monthly income is ₦150,000, my emergency fund goal, therefore, will be ₦750,000 (5 months x ₦150,000).

Step 2: Review your income and expenses

In order to effectively build an emergency fund, it’s important to know how much you can afford to contribute to it on a regular basis. It is not enough to just set a financial goal, you must also make sure it is a S.M.A.R.T financial goal. This means setting a Specific, Measurable, Achievable, Relevant, and Time-bound financial goal. The first thing to do to make your goal S.M.A.R.T is to review your monthly transactions in order to an idea of your monthly income and expenses.

Related: How to design a personal budget

If you receive a monthly salary then write this down under income, if you’re a contractor/freelancer and your income fluctuates then take your total income over the past 3 months and divide it by 3, this will give you your average monthly income, write this down under income.

Then under expenses, only note down your mandatory expenses. What are mandatory expenses? These are expenses that must be settled every month e.g. Rent, Transport, Groceries, School/Course fees, Credit card debt, etc. Expenses like going clubbing, clothes shopping, eating out are not mandatory expenses.

Now, subtract the expenses from your income to get what we’ll call your ‘Available Funds’; your monthly contribution to your emergency fund will be calculated based on this figure. A good rule of thumb is to save 50% of your available funds every month. That percentage might look a little high but the quicker you fill your emergency fund, the better, because your mind will be at peace and you can then focus on more exciting financial goals. I must insist that you save a minimum of 30% of your monthly available funds.

To illustrate how your emergency fund should be calculated and broken down in a S.M.A.R.T manner, let’s go through an example: Meet Niyi

Niyi (but not really)

Niyi is 23, works as a lawyer and earns ₦120,000 per month. Niyi took our emergency fund size quiz in step 1 and achieved a score of 16 which means the size should be 4 months. This means his emergency fund goal is ₦480,000 (₦120,000 x 4).

Niyi’s parent were thoughtful enough to open a savings account for him when he was younger and as a result he has ₦120,000 already saved up. This means Niyi now only has to save ₦360,000 (₦480,000 – ₦120,000) to build his emergency fund.

So at this point, Niyi has a specific goal of building an emergency goal to the measure of ₦360,000 that is relevant to him. The next step is to decide his monthly contribution to his emergency fund therefore assessing whether his target goal is achievable.

Niyi is originally from Kogi state, he decided to move to Lagos and now lives in Ikeja with his uncle. Unfortunately, Niyi has to pay ₦15,000 a month for rent as his uncle is struggling. He also drives to work and his fuel costs ₦25,000 per month (he works in Ikoyi). Niyi, being the good nephew he is, also buys ₦10,000 worth of groceries per month for the house. This comes to a total of ₦50,000 in mandatory expenses.

Niyi’s income = ₦120,000 and mandatory expenses = ₦50,000. This leaves him with available funds of ₦70,000. 50% of his available funds is ₦35,000, which is how much Niyi decides to contribute monthly to his emergency fund.

To make his goal time-bound, Niyi calculates how long it’ll take him to save ₦360,000 and finds out it’ll take him 10 months and 2weeks (₦360,000 ÷ ₦35,000)

Niyi now has a SMART goal, i.e.

Specific: He wants to build up his emergency fund.

Measurable: He knows his emergency fund should be ₦480,000.

Achievable: He knows he can afford to contribute ₦35,000 per month to his emergency fund.

Relevant: He knows his emergency fund will protect him against the volatile nature of life in Nigeria.

Time-bound: He plans to have fully built his emergency fund in 10 months and 2weeks.

Step 3: Pay Yourself First

Have you ever found yourself in a situation where you’re trying to understand why you’re not saving as much as you want to or not reaching any financial goals you’ve set?

Well earlier this year this is exactly how I felt. I would always tell myself ‘Next month I’ll save more!’, yet months passed and I wasn’t any better off. I noticed that the only time I put money in my account was at the end of the month, when I had spent 90% of my salary.

I confided in my friends, and was surprised to find out I wasn’t the only one with this problem. It’s actually a fairly common one. After hours of research, I came across an article that explained the concept of ‘paying yourself first’ and just like that, my problem was solved.

Paying yourself first simply means you’re prioritising your future self’s key financial goals e.g. building your emergency fund or saving for a house ahead of other financial concerns. This means that when you receive your monthly income, your emergency fund contribution (or any financial goal) is the first payment you make.

For this to work effectively, you should have two separate bank accounts; the first is your current account (or wherever you get paid) and the second is a savings account. If you receive your salary in your current account, your emergency fund contribution should be immediately transferred from this current account to your savings account.

After you’ve paid yourself first (taking care of your future self), you can then use what’s left in your current account to take care of your present self.

If there is one concept in personal finance that you should internalise, it should be the concept of paying yourself first. It helps shift your mindset from one which craves and only cares about instant gratification to one which is patient and appreciates long-term well-being.

Step 4: Automate Automate Automate

Although I learned how important paying myself first was, I still struggled to constantly practice this behaviour. It’s not something I could start doing overnight, my mind was so used to short-term gratification and just taking care of my present self. I thought my future self would sort himself out.

So I decided to help ease my transition to this new habit by simply automate the process. This meant I no longer had to transfer the money myself and contemplate if I really was going to go through with it. My salary came in on the 26th in my current account and before I checked my balance, my monthly emergency fund contribution had already been transferred to my savings account that same day!

The easiest way to do this is to set up a monthly recurring standing order between your current account (or wherever you get paid) and your savings account on the day you get paid. If the day you receive your income constantly changes, you could set up the standing order to take place on a weekly basis. All you have to do is take your monthly emergency fund contribution and divide it by 4 and set up the weekly standing order according to that figure.

Step 5: Track your goal

Staying motivated throughout the journey of building your emergency fund is hard, especially if you’re starting from zero. Trust me, when I initially went through the first 4 steps of this article and saw how long it would take me to achieve my goal I felt deflated. But it’s important to remember that you have to start from somewhere.

What really helped me throughout the process was tracking the progress to my emergency fund goal. This simple activity not only kept me motivated as I saw my savings account improve every month but it had the psychological effect of actually driving me to save more aggressively. I ended up reaching my savings goal 2 months earlier than I had planned!

The simplest way to track the progress to your goal is to take a sheet of paper or open a notebook app on your phone then write down the amount in your savings account and the number of months left till you reached your goal. That’s it. You only need to do this once a month as well, so pick a date and make sure to stick to the date you choose.

While I was building my emergency fund, I had a couple months where I reduced my monthly emergency fund contribution due to other financial goals like saving for a holiday took precedence. It’s important to not beat yourself down if this happens to you, all that matters is that every month, there is always an increase in the amount of your savings account (doesn’t matter how small it is). If you do have an emergency and need to withdraw from your emergency fund, that’s perfectly fine, that’s why these funds exist! Just start the process again of building it up and try to get back on track.

Challenge

On a parting note, I have a challenge for you – earlier I mentioned that I beat my initial target for the length of time to build by emergency fund by 2 months. Well, my challenge to you is to either match or beat my record!