So here is the big question. What is an Emergency Fund?
An emergency fund is your buffer between real life and an emergency.
There are more technical definitions, but for me, it is all about the basics.
My emergency fund is protection against life’s storms.
As a teenager, I used to always keep an emergency $20 hidden in my wallet. It only got used in – you guessed it – an emergency. Of course, at that point emergencies included last minute dinner invitations and stuff that really wasn’t an emergency.
The important thing was the concept and the habit I formed.
To this day, I always keep a $20 stashed in my car. I’m just spacey enough to forget my wallet occasionally and that $20 got me to work when I almost ran out of gas just last month.
Unfortunately, most emergencies aren’t going to be solved with a $20 bill. You are going to need a little bit more.
Financial planners recommend an emergency fund that will cover your expenses for 3-6 months.
I’ve chosen to do a 6-month fund because I’m a bit of a savings freak.
Every person’s requirements are slightly different. If you have young kids to support, a single income home, commission based income or potential employment issues, I’d highly recommend a larger fund.
You never know when that rainy day is going to hit.
This doesn’t mean you need to save up 6 month’s worth of salary. What it means is that you need to have money set aside to cover six months of expenses. If you are living paycheck to paycheck then yes it is your net salary.
Keep in mind that in a true emergency your costs are likely to decrease. If I were out of work my food, entertaining, gas and anything remotely considered fun money would decrease drastically.
What I’ve done for my emergency fund is put together a list of all of my normal monthly expenses, then I slashed the discretionary categories. I didn’t eliminate them, I just reduced them sharply.
Once I was done, I used these numbers as the basis of my emergency fund.
These are just estimates, but it gives you a good starting point to follow.
Once you figure out how much you need, it is time to start saving.
I really like Dave Ramsey’s perspective on the emergency fund. He advocates 8 Baby Steps – I’m focusing on the 1st and 3rd for this article. I highly recommend reading his book The Total Money Makeover for additional info.
- Save like crazy until you have at least 1,000 in your account.
- Once you have your basic emergency fund then it is time to pay off any consumer debt.
- Once your consumer debt is paid off then focus exclusively on a 3-6 month emergency fund.
All of this sounds really great in theory, but the actual steps can be a bit more problematic in real life.
To start your emergency fund I recommend the following 5 Steps:
1. Budget, budget budget
Organize your personal finance and live within your means. I’ve hammered this point in previous blogs so check them out for helpful budgeting hints.
2. Prioritize your savings goals.
The trick is to always pay yourself first. Take a small amount out of each paycheck and put it aside for your rainy day. Continually find ways of savings until you hit your goal. Once you are used to living on a budget starting finding the extra’s and stock them away.
I know people who put aside every $5 bill they receive. I have friends who round up every purchase and put the difference in a saving account. All of these are great steps. The important thing is taking the step to save.
I constantly tell my kids, it isn’t about the amount, it is about the habit. If all you can save is $1 a day start there. You’ll be amazed at how quickly your account grows.
For additional ways to save check out: 7 Simple Ways to Start Saving Money Now.
3. Keep your emergency fund liquid, but not too liquid
For me, I’ve chosen to keep my emergency fund in a completely separate bank from my normal operating accounts. I have mine held at ING Direct (now Capital One), they seriously have the best banking website I’ve ever used.
I can transfer funds back and forth from my operating account, but the transfers take 3-5 business days.
This means the money is liquid, but not super easy to get to. Knowing I can’t instantly access my Emergency fund really incentivizes me to plan ahead.
4. Decide what you consider an emergency
Everyone has different priorities and issues. For Aaron and I, we’ve decided that emergencies are pretty cut and dried. We try to only dig into our emergency fund for unexpected life shaking events.
We don’t dig into our emergency fund to buy toys, or to pay for fun extras. We don’t use the funds to pay off credit cards or finance vacations. We only dig into the emergency fund for unexpected medical expenses, major home/car repairs and stuff of that caliber.
I’ve always felt like if it something I can anticipate then I ought to be budgeting for it.
Now, I should probably mention that we haven’t been perfect in this area.
We pulled a bunch of money out of our emergency fund for what we thought was going to be a really great investment opportunity. Based on current trends it was a horrible decision and we will most likely be losing the money (yet another reason to stick to the rules). **editorial note – we ended up losing over $50,000 because of a poor business decision. You can read about it here: What I learned from the Failure of My Business.
We recently pulled some money for renovations to my old house that we are preparing to sell. I know the renovations are needed and we will easily make up the money when we sell the home, but this is something I’ve known was coming for months and I should have been budgeting for it.
I guess what I’m saying is that this is always a work in progress. If it isn’t an emergency don’t use the money.
***Editors Note – I recently wrote a post entitled Four Questions to ask before using your Emergency Fund that goes into more detail on this subject.
5. Your emergency fund isn’t an investment
This is one I really struggle with. I like investing my money into mutual funds and having a large chunk of money just sitting in the bank earning less than 1% interest kills me.
What I’ve come to realize is that the peace of mind it gives me is worth more than all the interest in the world. When my A/C unit broke in July (I live in Phoenix) a few years ago, the interest I could have earned on the money in my emergency fund was the last thing on my mind. Rather than stress about the repair, I paid in cash (which incidentally got me a discount).
Saving for an emergency fund is hard, not spending the emergency fund for fun stuff is hard, seeing the money just sitting there earning virtually no interest is hard.
I’ll tell you what else is hard, – having an emergency and no money.
Just think back to your last emergency and think about how different the experience would have been if you had an emergency fund?
It paints a different picture, doesn’t it?
Please share if you know anyone who would benefit from the article.
***Shortly after I wrote this post my husband’s company went out of business. Fortunately, we had just completed our 6-month emergency fund and had paid off $293,000 in debt. I wrote a post How We Paid Off $293,000 in Debt in Five Years that talks about our experience. Needless to say, I was very thankful for our emergency fund.
Photo Credit: Luis