Last week, I compared the benefits and drawbacks of growing an emergency fund versus paying down your mortgage faster. There was a lot of great discussion and commentary on that post; however, I feel that many might have gotten the impression that I was advocating a more aggressive position than I truly believe in.
I’m going to go into more detail on a couple of additional concepts of which the emergency fund plays but a part: financial health, and financial strength. I’m going to use the analogy of a field with crops to introduce these two concepts.
Let’s pretend that each of your dollars represents a seed in a field. When your financial health is good, then you are taking good care of your field. Your seeds are flourishing into healthy crops, which produce plenty of seed for the next year. When your financial health is bad, you are neglecting your field. Your crops are weak, your harvest is bad, and you barely have any seeds left over to survive.
Financial strength represents the resilience of your crops to hardship and disease. A field that contains only one crop is more vulnerable to pestilence and disease than are fields that contain more than one crop. Pestilence and disease can happen in the multi-crop fields, too, but they are less likely to affect all crops equally. By diversifying across asset classes, the weaknesses of some of your investments can be covered by the strengths of others.
To put it simply:
Financial health: How flexible are your finances? How far away are you from disaster?
Financial strength: Where is your money, and what is it doing? Are the weaknesses of some of your holdings covered by the strengths of others?
Today, I’ll talk about financial health in more detail.
Some people debate whether you should carry three months expenses in cash, six months, or even twelve months. I personally believe that having some buffer is good, and I usually keep about two to three months, myself. Beyond that, I prefer to invest or pay down debt.
To analyze financial health, I want to look at a basic metric: How much of your net income goes into basic expenses? How much of your income goes into debt service? Are you leaving sufficient room for growth?
How much of your paycheck do you use for the basics?
While having a buffer is important, there is another concept which I’d like to introduce which I believe is even more important: assuming that you get paid every two weeks, How many paychecks do you need to consume per month to survive? According to a recent poll, about six in ten Canadians are currently living pay to pay: they would be in trouble if their pay was delayed by a week. This is in part due to our current very high debt levels. How do people get themselves into this kind of situation? It’s very easy: they spend as much as they earn, and they get themselves into consumer and mortgage debt.
I want all of you to do a little activity right now: First, add up all of your monthly expenses: if you live in an apartment, add your rent, electricity costs, and heating costs together. If you live in a purchased property, then add your mortgage, property tax, and other related expenses together. Now take these monthly expenses, and add your food, gas, car maintenance, internet, tuition, and subway expenses together. Add everything that you can’t really do without.
Once you have your base monthly expenses calculated, then take your net income on your paycheck after taxes and all deductions (ok, ok, you don’t have to deduct your voluntary retirement plan, so you can include that as income, but only your portion and not the match. For my own number, I left this as a deduction from my paycheck). You’re not allowed to amortize bonuses or other special payments into this amount. I want you to calculate two numbers:
- Assuming you get paid every two weeks, how many paychecks does it take to pay off your base expenses?
- On a monthly basis, how much of your income is consumed by your base expenses?
They both represent the same thing, but the first number is easier to visualize conceptually in terms of paychecks.
Formula for first number: (monthly expenses) / (bi-weekly net income)
Formula for second number: (first number / 2.16)
If you don’t get paid every two weeks, then here are a couple of formulas for converting between different periods:
- Semi-monthly to bi-weekly: Divide by 1.08.
- Monthly to bi-weekly: Divide by 2.16.
In my case, I get paid every two weeks (bi-weekly). I divided my monthly expenses by my net income on my paycheck, and I came up with 1.29. This means that it takes 1.29 of my paychecks to cover all the expenses I need to cover the necessities of life. I took my rent, car, etc…. altogether and then I added an extra $200 for good measure. On a monthly basis, my base expenses represent about 60% of my net income after all taxes and deductions.
Here’s how my numbers look:
|How many bi-weekly paychecks does it take to pay off my base expenses?||1.29|
|How much of my net income is eaten by my base expenses?||60%|
What does this mean?
First, it means I could lose up to 40% of my after-tax income and still survive. I would not be able to save anything and I would have to slowly eat into the money I have for contingencies, but I would survive. As I pay up to 40% in deductions and taxation is “progressive”, that means I could still get by even after losing 50% of gross income. This gives me a lot of breathing room.
Second, so long as I have my income, I can fund unexpected contingencies out of my current income. If I have an unexpected bill that costs me a whole extra paycheck, I simply don’t eat out or save for an extra three weeks or so.
Finally, I have plenty of disposable income that I can redirect toward savings, investing, and paying down debt.
Where is the danger point?
Frankly, it worries me that six out of ten Canadians are living paycheck to paycheck. I used to live paycheck to paycheck when I was a student working part-time, but I had a minimum-wage income and a lot of expenses. I simply don’t see why six out of ten Canadians should be living so close to the margins other than by having taken on excessive debt.
Living paycheck to paycheck means that you likely need two whole paychecks per month to cover your base expenses, and these base expenses consume up to 90% or more of your net salary. This is dangerous. If you look at the three points I established before, here is what could happen:
First, if you lose half your gross salary, you will be forced to consume your emergency fund until you go bankrupt. All an emergency fund will do here is buy you time, but it won’t put off the inevitable until you recover your income or lower your expenses by getting rid of debt-heavy assets.
Second, even if you retain your income, it is still impossible to fund extra contingencies out of income. You will be forced to go into debt or sell off assets.
Finally, it is very difficult to save, invest, or accelerate the payment of debt when you are living close to the margins.
What is your number?
As you see, an emergency fund is basically that: something that only helps you in an emergency. It is an important part of your strategy, but it is very important that you have a strategy for prosperity, as well. If you are only planning for an emergency without also planning for a surplus, then you are planning for trouble. I much prefer that you lessen the chances of finding yourself in an emergency situation in the first place by encouraging a culture of surplus. How do you do this? You do this by putting a lot of distance between your expenses and your income. There are two basic ways to do this:
If you do even better than me and can save half or more of your net income, then you are doing very well.
So, reader, what does your number look like? Do you have an adequate buffer between expenses and income? I feel that I can still do better, especially as my expenses will be rising somewhat within the next few months as I move from an apartment into a condo. I would be happy if all expenses could fit into one paycheck, not including bonuses or anything like that. I’d love to hear your take on things.