MoneyLife

What is a Financial Safety Net?

By Anna Yen
What is a Financial Safety Net

Thirty-five percent of non-retired Americans had to tap into their nest egg when the pandemic hit. Even before COVID-19, only 41% of people could cover an unexpected expense of $1,000 or more without charging their credit card or borrowing money. 

Without a financial safety net, you’ll have little-to-no means of dealing with a sudden expense. As the pandemic taught us, financial risks, like losing your job or getting ill, could cause major changes. And these changes make it harder than usual to make ends meet. 

What is a financial safety net and how does it work?

After creating a cash budget and deciding on your long-term investment goals, you need to plan for the unexpected. Building a financial safety net is the next crucial step to achieving financial freedom. 

Your financial safety net refers to all of your assets. When something unexpected like the pandemic strikes, your safety net should help you stay afloat financially. So, if you lose your job, fall ill, or your business goes bankrupt, everything will be okay because you’ll have a fallback plan. 

Just as a physical safety net could prevent you from a bad fall, a financial safety net gives you the means to brace yourself against unexpected expenses. In the next sections, we will cover the most frequently asked questions about a financial safety net.

Why do you need a financial safety net? 

Everyone needs a financial safety net. Whether you are single or married, young or old, you need measures in place for difficult times.

A financial safety net will not completely eliminate all of life’s risks, but it will help you pay for basic needs when something unexpected happens to you or your family. 

What makes up a solid financial safety net? 

A financial safety net will offset the risk of you getting derailed from your financial goals. At a minimum, you need to have the following items on your risk-reducing portfolio:

  • Emergency fund 
  • Disability insurance
  • Life insurance
  • Retirement fund

By combining these assets, you’ll feel more financially prepared for emergencies. Your safety net portfolio allows you to pay for basic needs even if you lose your job, your income-generating ability, or any other form of financial setbacks. Life insurance protects your dependents, and retirement funds help you save for your older years. When all else fails, drawing on your retirement can be a lifeline. 

How much of a financial safety net should you have?

You need to recognize that your past expenses may not represent your future expenses. And your future expenses are usually guided by bigger ticket items you have that begin to fail suddenly.
For instance, most used car buyers don’t recognize that the deal they may be getting when they buy that used car is coming with future repairs as unexpected expenses.
As a pet owner, you may not realize how expensive a visit to a pet emergency visit could cost you many thousands even though you have pet insurance.

Your monthly expenses are always the starting point when you’re building your financial safety net. From there, decide how many months you want your safety net to cover. Think how long you could survive on your savings if your spouse loses their job tomorrow. Include the bills, utilities, mortgage, and other necessities in your calculations. 

While emergency funds are not the only option, they’re the easiest solution when it comes to immediate needs, like an unexpected bill from a surprise plumbing malfunction. Experts recommend building emergency funds that cover three to six months of your monthly expenses.

If you’re a renter and you’re single, a three-month emergency fund might be enough. But if you have kids or a mortgage, sticking to six or twelve months would provide greater security. 

Considering the average unemployment period is roughly five months, a six-month emergency fund should be viewed as the bare minimum. So, if you’re spending $3,500 a month on your living expenses, you need to keep at least $21,000 in your emergency fund. 

For freelancers and self-employed individuals, shooting for a nine-to-twelve month emergency fund provides a margin of safety that is more suitable for your lifestyle. But if you’re struggling with money, experts advise aiming for a minimum savings value of $2,467 at the least.

While having emergency funds is handy, your savings will not last indefinitely. What if you have medical expenses that pop up due to disability? Could you survive on only Social Security without other financial safety nets? If your paychecks stop coming in, your emergency funds will eventually be depleted. You need to devise a way to make up for the loss of paychecks, which is where short- and long-term disability insurance comes into play. 

When you can’t work because of a disability, Social Security can cover some expenses, but it won’t cover everything. It’s better to have disability insurance which will cover at least two-thirds of your basic salary. 

Disability insurance strengthens your financial safety net. Life insurance works in the same way for your dependents should you pass away. 

What are the consequences of not having a financial safety net? 

Without a financial safety net, you could end up unemployed or saddled with unpaid bills. Emergency funds or savings accounts help you get back on your feet. But without them, meeting you and your family’s basic needs could be difficult. 

You may end up having to borrow money from family and friends. In worst-case scenarios, you may have to apply for high-interest loans or take on additional credit card debt.

If your credit scores fall because you don’t have the means to pay back your debt, borrowing could become even more expensive in the future. Your financial safety net will help you cope with emergencies and avoid getting in debt for the sake of providing for yourself or your family.

Difference between a cash reserve vs safety net

As mentioned above, your financial safety net is a bundle of risk-reducing measures. Cash reserves could be one part of that portfolio. Cash reserves are readily available when you need them, and they are often part of your emergency fund, not your checking account. 

When you compare emergency fund vs savings, think of the emergency fund as funds for immediate cash needs while the latter is for a specific goal, like buying a car or putting a down payment on your home. As a result, emergency funds are often held in a savings account that can earn interest. 

Differences aside, both cash reserves and investments can help strengthen your financial safety net through diversification. 

Build a strong financial safety net  

Experts recommend having emergency funds to improve your financial security. But what you’ve planned for may not be enough. Start with emergency funds using cash reserves, but don’t forget to shop for affordable insurance disability and life insurance. Diversifying your safety net with savings, insurance, and investments can help you prepare for life’s uncertainties.

If you want your savings to grow into an even larger buffer, you might want to consider investing in stocks. For only $1 per month and no minimum balance requirements, investing with MoneyLion means your money will work as hard as you do.

Sign Up
Sign Up

Discover effortless investing

We'll help grow your money using the same techniques trusted by some of the countries' wealthiest investors, even if you start with $5. Get your personalized, fully managed portfolio now.

Sign Up