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Why You Need an Emergency Fund and How to Start One

by Ryan Guina

Unemployment. A car accident. A medical emergency. Even the best laid plans can go awry, and the last thing you want to worry about in a time of crisis is how you are going to get by financially. Life is full of unplanned events, which is why everyone needs an emergency fund.

Why you need an emergency fund

you need an emergency fund

You need an emergency fund for life's rainy days

If you are living paycheck to paycheck and don’t have any cash reserves, even a minor financial emergency can set you back months – causing you to get into debt and increasing the amount you owe creditors. An emergency fund can help you avoid that situation. By planning for the unplanned, you relieve stress, reduce risk, and increase your financial flexibility.

Where to open an emergency fund

You want the money to be liquid so you can have access to it at a moment’s notice, and you also want to ensure your money retains its value. Your emergency fund isn’t designed to grow wealth, it is designed to preserve your financial flexibility and help prevent you from going into debt. So you don’t want to keep your emergency fund in stocks or mutual funds which can vary substantially according to the markets and may take several days to cash out and transfer the funds to your bank account.

The best places to keep your emergency fund are accounts that offer quick access and a stable rate of return. Some good examples include savings accounts, money market accounts, CD’s, and Checking Accounts. Be sure to find a bank that offers high interest rates because the idea is to let the money sit there until needed. You can check with your local brick and mortar bank or credit union, or use an online savings account.

Consider a CD Ladder for your emergency fund. A CD Ladder allows you to stagger your CDs so you can earn more money than a standard savings account and still have access to the money on a regular basis.

How much should be in your emergency fund?

This is an area where each expert has an opinion, and the answers vary. Some people recommend at least 3-6 months living expenses, some recommend 6 months to a year, and some recommend a few thousand dollars. In my opinion, this is a very personal decision and should be based on your individual circumstances.

If you have no debt and minimal living expenses, you can probably get away with a smaller emergency fund than someone who carries a large amount of debt and has high monthly living expenses. Another factor to consider is your income and employment status. Someone who works for the government or in a stable industry may keep less than someone who is self-employed or works in a volatile industry that often experiences layoffs or seasonal work. As a rule of thumb I would start with $1,000 at the minimum, then work up from there to a level that gives you the financial flexibility you are seeking.

What does Dave Ramsey recommend? Dave Ramsey’s Baby Steps are a financial plan to get out of debt and become financially free. Dave Ramsey recommends starting with a $1,000 emergency fund, paying off all debts except for your mortgage, then saving from 3-6 months of expenses before moving to the next step, investing 15% of your household income.

How do you fund it?

Hopefully you have a good understanding of your cash flow (a working budget is helpful here). This will make it easier to find areas where you can free up cash to divert to your emergency fund. Consider treating your emergency fund like a bill and sending a predetermined amount to your emergency fund each pay cycle, or month. A good way to do this is to automate it through automatic deduction or payroll deduction. You can also find areas to cut back from your regular budget, or send any overages to your emergency fund. For example, if you budget $500 for groceries and only spend $400, you can save the $100 toward your rainy day fund instead of spending it elsewhere. Other ideas include funding your account with bonuses, tax returns, income from a side job, etc.

What about using credit cards or other credit for emergencies?

The point of an emergency fund is to avoid using credit for unexpected expenses, so while using a credit card or another loan is certainly an option, it is one that should be a near the end of the list. Using credit for an emergency can make the problem worse because it will put you deeper into debt. The clock is always running on the interest and it may take you months or even years to repay the loan. Credit cards and other loans can be convenient when you take them, but it is rarely convenient to repay them.

What about tapping into retirement funds?

This should be considered a last case scenario because can set your retirement planning back several years. You can repay a 401k loan, but it will still end up hurting your retirement fund. If you make a withdrawal from a retirement account instead of taking a loan then you will be subjected to immediate taxes and possibly early withdrawal penalties if you are under the minimum withdrawal age.

One of the best financial decisions you can make

An emergency fund is one of the most important financial steps you can take after becoming current on your living expenses and graduating from living paycheck to paycheck. And with a little planning and luck, it can help you manage unexpected expenses and avoid going into debt.

Photo credit: bradipo


Published or updated March 21, 2012.
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{ 8 comments… read them below or add one }

1 Financial Samurai

Sometimes, everyday is treated as an emergency, that’s why it becomes so hard to save. If more people would follow my “going broke to win big” methodology, I think more folks would have more money saved.

Go out there and flush as much money as you possible can out of your “go broke” bank, and into your investment bank and debt bank. Optimize your cash flow!

FS

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2 Hank

Great post! I was actually blown away when I finally sat down and calculated our 3-6 months of living expenses. The number was really quite larger than I had thought. My goal was originally to save $10,000 as an emergency fund, but I actually have $3,000 of living expenses including the mortgage that I absolutely have to pay. So, six months of expenses is more like $18,000 that I need.

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3 Ryan

I think a lot of people are surprised when they run the numbers. It’s even more difficult to handle unexpected expenses or unemployment when you live paycheck to paycheck or if you don’t know how much your normal expenses run each month.

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4 Brad Castro

Good article.

For those with zero savings right now, I think the $1000 target is a more important initial objective than trying to save up several months’ expenses.

Once you have that initial $1000 put away, you’ve shown yourself that you can, in fact, save money. All you have to do is continue. And having an extra $1000 in the bank will also go a long way to giving you a sense of empowerment that will help you achieve future financial goals more easily.

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5 Financial Samurai

Brad – What is $1,000 though? That’s just an arbitrary #. Definitely important to actually calculate the expenses necessary for at least 12 months and create the EF fund like Hank says above.

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6 Curious Cat Investing Blog

An emergency fund is a very important part of your financial plan. I think the amount is somewhat personal but also must factor in economic reality to be useful. I suggest a target of 6 months be the minimum. 4 months is better than 2 but really I would not be comfortable under 6 (and many people every year – especially now in this economy) will get into trouble even with a 6 month emergency fund. Most can’t get there right away, but that should be what you are aiming for (or longer). And, with dependents, I would aim for a larger period. Also don’t skip on disability insurance.

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7 mewithoutdebt

Emergency fund is good idea for people who have debt payed off and are in saving mode. However, I think it is counter productive for people who are still in debt. You can read more at http://www.mewithoutdebt.com/2009/11/feeling-broke-is-good.html

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8 Ryan

mewithoutdebt, That may be a good way for some people to manage it, but I think others may benefit from having a cushion to prevent using their credit cards for any unexpected expenses. There are many ways to deal with personal finances and the key is finding what works for you.

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