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:
- Reduce your expenses (Yakezie link).
- Increase your income (Yakezie link).
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.
Our buffer is definitely not what I would like it to be right now since I stopped working. I am hoping to grow the blog and some other things and increase our income. Right now though, our number is 1.6. Not real impressive, I know. However, a lot of our salary comes twice a year in bonuses, which are somewhat fixed. But, I don’t like to count on bonuses because you never know when they will change the bonus plan. I do know though that if things got real rough, I could go out and find some kind of job, even if it wasn’t real high paying. We could also eliminate travel sports and such.
At 1.6 you still have a good 25% of your income that you have available, and then you have your bonuses in addition. If we were only one worker, my number would probably go up to 1.6, too, especially after moving to the condo.
Although I didn’t amortize my bonuses either, I’ve never not received one. At the worst it’s smaller than normal. I just like to exclude it here as I find it’s better to underestimate your income rather than overestimate it!
I’m also with you with growing the blog! You’ve been doing pretty well, and I hope to keep growing mine as well. I’m looking forward to the next challenge!
In my opinion, having a part time job and a full time job helps. I usually spend all my part time job earnings to rent, food and all other expenses leaving my full time job earnings to stay in the bank untouched. Its really not hard to do a full time and a part time as along as the part time job is flexible and enjoyable. I still have time to go out and enjoy the weekend 🙂
Hi Das,
That is a very good point that you brought up. What I’m personally trying to do over the medium run is turn my web activities into my part-time job that can pay the rent, food, and car, thus leaving my full-time job to go straight into the bank. That would be really great 🙂
Knowing your expenses does help your measure of your financial health or lack thereof. Like you, I don’t understand how people can be so comfortable without more buffer in their budgets. The “emergency fund” in its truest form is just money that you have designated for emergencies. Still, there are spending considerations, such as you propose, that are key.
Yep. An emergency fund is like the airbag in your car, but the focus should be on driving safely so there is less risk of having to rely on that airbag. Just because I know the airbag is there doesn’t mean I’m keen on using it. OTOH, it might induce me to drive a little more dangerously 😉
By reducing expenses and increasing income, you have surplus you can use to pay down debts and invest, and this will provide you with much greater security over time.
Cool exercise! My number is .625 because I have very few (and almost all very low) fixed expenses. That number although could have been improved if you hadn’t had that pesky “after ALL deductions” line in there. (I have 30% of my salary going to my 401k right now.)
Very nice number. I do suppose that voluntary retirement does not need to be counted as a deduction 😉
Kevin,
I like the way you challenge us to look at our finances from a new and different perspective. My number is 0.5, but before you hyperventilate, I only get paid once a month…meaning I could survive on half of what I get. But, to keep things in perspective, I am retired and have a paid for house and zero debt. It hasn’t always been that way!
Your financial house seems to be built out of solid bricks. You could be a good example to fellow Americans & Canadians!
Excellent post. At one point I was at less than 25% and it was wonderful. I’m not there now but now that I know how it feels I want to do the work to get back there. In the meantime, reducing all needed expenses is a big help. I am now working the “how long can I go without a car?” and realized I was at 11 months. For some cities that might not be unusual but for me it is a victory.
I tried the carless thing, but I simply found it too inconvenient. That said, it really does help you save on a ton of expenses when you’re not paying for gas, maintenance, insurance, etc….
My income varies a lot and for my time in Canada I was living pay check to paycheck because of large debts and repayments.
However since I got things under management, moved to Egypt and increased my income I have started living on much less. This month I will be living on about 30% of my income. Most months in recent times I have been living on about 50%.
That’s pretty good! That’s a lot of money you can devote toward paying down that debt and growing your savings.
Another way to look at it is if that number goes down over time. I am in a much better financial position than I was 5 years ago..because I paid off a ton of mortgage debt in that time. Plus, our incomes have gone up as well.
It could be a good barometer for lifestyle inflation. By January, we should be able to save over 1/2 our income. We save about 20% now. The rest goes to mortgage debt and fun.
I really do think it’s hard to get ahead in your 20’s and early 30’s when you’re buying houses, furnishing them, having kids, childcare, buying cars. It’s just lately (I’m 37) that I’m feeling like I’ve got money leftover each month.
I only started saving significant amounts of money since I graduated and started working full-time. Young 20 somethings can greatly improve their odds by avoiding debt and conspicuous consumption, though!
I’m unemployed at the moment, but starting a new job on Monday. I will get paid biweekly and it will take about 60% of one paycheck to cover my expenses because the house is paid off, and I have no debt and relatively low expenses. Having no debt adds a lot of flexibility to weather the bad times.
Seems like getting rid of debt really helps one’s flexibility!
We’re about 1.4, no complaints with that! I don’t think 6/10 is that far off, probably fairly accurate, but it doesn’t mean that’s good either…
Good post Kevin.
The Canadians seem to have a higher load than the Americans. I wonder if that’s due to small sample size or why that is… it’s interesting!
We live on somewhere between my paycheck and my husband’s paycheck. So a bit more than half our income is spent each month. Our fixed expenses are about 33% of our joint income, so we could cut quite a bit of happiness out of each month in case of emergency.
It’s great to have that large amount of head room in case things get a little tough!
Since my income fluctuates from month to month or season to season, I have to set aside any additional money for slimmer months. Though I don’t consider myself to be living paycheck to paycheck, I don’t have nearly as much saved up as I would like. I also wonder what the formula would be on a quarterly calculation. Perhaps .54? If I worked it out with this formula, I can see that I’m lagging behind. I should have $10,000 saved and I don’t!
Yep, it’s more important to have more of a buffer when you have a variable income. That’s one of the tough things about going complete free-lancing.
Without debt payments our number is about 1.1. However, add in our debt repayment and I won’t even write that number!
This is a great concept and it should be a real “eye-opener” for people who have a low number, but aren’t saving!
Right now I don’t have any debt payments in that number, but next year will be different. Time to take on a mortgage. :S