Unemployment. A car accident. A medical emergency. You never know when a financial emergency will strike. The last thing you want to worry about in a time of crisis is how you are going to get by financially. Your budget needs to be prepared for these unexpected events. This is why everyone needs an emergency fund.
People tend to have their own definitions of what an emergency fund is, what it means to them, and how large it should be. And that is fine. You need to do what works for your situation. We’ll cover these topics, and much more in this article. We want you to be prepared to handle any financial emergency that may arise. And your emergency fund is the best place to start. We’ll also give you some ideas for other ways you can protect yourself and your financial situation.
Why You Need an Emergency Fund
Financial emergencies come in all shapes and sizes. There are certain things you can do to protect yourself and your finances, such as buy appropriate amounts of insurance (home, auto, life, medical, etc.). Insurance shifts risk and can offer the policy holder financial relief when they need it.
But insurance may not cover the entirety of every financial emergency. That is why you need an emergency fund. To help cover unexpected financial needs.
For example, 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.
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.
Where most experts agree is that you should base your emergency fund on your expenses, not your income. So if you measure your emergency fund in months, it makes more sense to measure in months of expenses, not your income.
How large should your emergency fund be? 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 is 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 a $1,000 emergency fund (at the minimum). Then work up from there to a level that gives you the financial flexibility you are seeking.
How large is my emergency fund? I am self-employed, so I feel better having a larger emergency fund to make sure I have cash on hand if anything pops up. My cash flow can also be irregular. So having cash on hand reduces risk. In my case, I started with the $1,000 emergency fund, then built it up to the $10,000 mark. Now I keep at least 6 months of living expenses in cash – just in case. Having this amount of cash on hand helps my rest easily, knowing that I am prepared for just about any issue that may arise.
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.
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.
Keep emergency funds separate. It’s also a good idea to separate your emergency funds from your primary checking or savings account. You want the money to be accessible if you need it, but not so accessible that it is mixed with your regular funds or that you are tempted to spend it. You can usually transfer money between banks within 1-3 days. So keeping your emergency fund in a separate savings account is a great way to avoid the temptation to spend it on non-critical expenses.
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 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.
You don’t have to fund it all at once. Many people can’t afford to simply earmark several thousand dollars for a financial emergency right away. That’s OK. But it’s a good idea to get started, and to make it automatic, if possible. Start by transferring the amount you can afford to a separate savings account. You can do any amount you want, just keep in mind the faster you build your emergency fund, the faster you will have that insurance against unexpected expenses.
You could start by transferring $50 per pay check, or $100 per month, or any number that works for your budget.
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.
I recommend not using a HELOC for financial emergencies, unless it is completely unavoidable. Your HELOC is tied to your home equity, meaning you are using your home to secure the loan. If you don’t repay that amount, you could lose your home.
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.
Beyond the Emergency Fund – Other Ways You Can Protect Yourself Financially
Every so often it’s a good idea to review your budget to see how your cash flow is doing. Being familiar with your budget will help you identify areas where you can cut back if you come upon a situation where you may need to make long-term lifestyle changes or if you need to make changes to your spending habits. These can be both planned and unplanned situations – not just emergencies.
Prepare for Possible Changes to Your Financial Situation
Here are some scenarios to consider:
- Changing from a two-income household to a one-income household (stay at home spouse, retirement, etc.).
- Death of a loved one (estate planning, wills, adequate life insurance).
- Other emergencies (illness, disability, natural disasters, etc.)
None of these situations are pleasant to think about. But it’s important to do so. A little planning on the front end can save you and your family from a major financial disaster.
How You Can Mitigate the Issues
Thankfully, there are some steps you can take to mitigate the above situations, with the proper insurance policies, estate planning documents, and other planning.
Look for budget cuts. When faced with a longer-term situation, you will most likely need to make big changes in your spending patterns. That will include cutting back in some areas. Going through your budget now and making a mental note of areas where you can cut expenses will make that process easier if an emergency strikes.
Can you increase income? It’s also a good idea to look for ways to increase income, especially in the event of a job loss. This could be through taking a part time job, selling things, or other ways you can make money fast.
An Emergency Fund is 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.