How to Build a Financial Safety Net for Financial Security

In personal financial planning, building a financial safety net is an important step. Once you have control over your day-to-day finances and have taken a look at your long-term financial goals, you are in the prime position to build a safety net. This can help prevent financial disasters from disrupting your financial security or goals.

Learn more about why a safety net is important and how to build one.

What Is a Financial Safety Net?

A financial safety net is not one savings account or an insurance policy. Rather, it is a comprehensive portfolio of measures that help you reduce risk. A financial safety net is meant to protect you and your family, at least in part, from losing your financial security or derailing your long-term financial goals. This is especially true in the case of some unexpected event, such as an illness or personal tragedy.

Of course, you cannot insure against everything. Nor should you try. But there are a variety of measures you can take to start building your personal financial safety net.

Do You Need an Emergency Fund?

Sometimes also known as a "rainy day" fund, an emergency fund is most often a stash of money held in a liquid savings account. It is set aside for unexpected events that carry some financial impact. These could include things such as losing your job, medical bills, or needed home or car repairs. It is the most basic piece of your safety net.

The only objective for this money is that it is easy to access when you need it. It should help you avoid taking on credit card debt when emergency costs arise. That is why this fund should be made up of money that you have agreed not to touch under normal circumstances.

The importance of an emergency fund is generally agreed on by financial experts. But there is no one universal rule for how much should be saved in such a fund. Many experts suggest having enough savings in this type of account to cover your living expenses for three to six months. This could help in the event of illness, job loss, or other serious emergencies.

The amount you choose should depend on your unique circumstances; for instance, how stable your job is, whether your spouse works, and what your fixed living expenses look like. Either way, some emergency savings is better than none. So even if you can't put in a lot right now, go ahead and add "save to emergency fund" to your monthly budget.

Do You Need Disability Insurance?

Long-term disability insurance helps replace your income if you are unable to work due to illness or injury. Many people consider this coverage a luxury. But it should be thought of as a necessity. This is even more true for those who don't have other financial resources they could tap in the event of a long-term illness or injury.

Even if you do have other financial resources, ask yourself this: Would you want to use them to pay your monthly bills? For instance, let's say you saved 5% of your income each year. A six-month disability would eat up 10 years of savings.

Don't think it could happen to you? Although your chances of having a disability increase as you get older, illness and injury can happen at any age. Car accidents, sports injuries, back injuries, and disease are just a few examples. The likelihood of being disabled is far greater for most people than the likelihood of dying during a given period of time. And millions of people carry life insurance (another important piece of your financial safety net). But they don't carry disability insurance.

Ask yourself this question: Could you and your family live without your income for three months? Hopefully, the answer is yes since you've built up that emergency fund. But what about six months? Or a year? What if you not only have to live without your income, but you also have the added expense of medical bills?

If the answer is no, you should consider disability insurance. Employers often offer this coverage via a payroll deduction. This may be tax-deductible and more affordable than one-off policies through an insurance agent.

Do You Need Life Insurance?

Life insurance is often a necessity for your financial safety net if you have dependents who would suffer financially if you were to die. Dependents often include children and/or a spouse.

Ask yourself: What would my family do to pay the mortgage or buy groceries if I were to die? Life insurance is meant to provide the funds for your family to have some financial security should they lose your source of income due to your death.

But life insurance is not only for the main earner in your family. If your family includes a stay-at-home parent, for instance, consider what it might cost to replace the work they do for the household. If that spouse were to pass away, would you need to secure daycare for your children? Would you need to secure household help? Could you afford these expenses based on your current income?

If you have no dependents, on the other hand, life insurance may not be necessary for your financial safety net. However, many people also use life insurance as part of their estate planning. This may be true even if they don't have dependents.

If you plan to buy life insurance other than that provided by your employer, you should learn about the pros and cons. Find out the differences between term, whole life, and other types of insurance. You may also want to talk to an advisor about how much insurance is enough for you. Each person's situation is unique.

The Bottom Line

You can protect your ability to make money with disability insurance. You can protect your dependents with life insurance. And you can protect your other assets with a six-month emergency fund.

At that point, your financial safety net is in place. Now, you're ready to turn to the task of accumulating wealth.