What’s that? Oh…I see…you are just getting started with the “getting-my-financial-act-together” bit and don’t know where to begin. Well welcome to Emergency Fund Basics, the first step to success in all other areas of personal finance.
That may seem like a bold statement, saying that an emergency fund is the basis upon which all other financial decisions should be built. I can attest though, from personal experience, having money set aside strictly for emergencies is the #1 strategy that has propelled us forward in paying off debt, saving for retirement and college and investing in the stock market.
Why is that?
Because it’s a fact – emergencies are going to come and we will have to manage through the crisis. Sometimes they will rain in droves.
If cash is not available to take care of the emergency the moment it hits our door, then we are really only faced with one alternative – go into debt to deal with the situation. And the constant accumulation of debt hinders our ability to accumulate great wealth over time. The “going-into-debt-to-solve-the-emergency” cycle MUST be broken.
So today I’d like to outline the basics of the emergency fund process. You’ll learn when to start one, what to use it for, how much to save and the best way(s) to fund it.
What is an emergency fund?
As you’ve probably already guessed, an emergency fund is an account in which to accumulate savings for when an unexpected crisis arises. This money is best kept in a traditional savings account at your local bank so it can be accessed quickly.
In what instances should I use the emergency fund?
You will use your emergency fund all the time. “All the time” for us has meant several times each year.
We’ve used our emergency fund multiple times to replace appliances around the house, fund car repairs, fix heating and cooling units, and deal with medical expenses. Any situation that creates a daily hardship that is excessive would qualify. Of course that definition is subjective based on the person’s definition of “excessive.”
To my thinking, fixing a car so it can be driven to work, repairing a furnace in the middle of winter or getting a cast on a broken arm are examples for which emergency funds could be used. Issues such as fixing a broken dishwasher, replacing a faulty PS3 or repairing an inoperative garage door do not qualify.
The first three create immediate conflicts that alter life. The latter three, while inconvenient, can be put off and managed for a time until sufficient funds can be saved to correct the issue.
And the emergency fund is clearly not a late night pizza fund, an “I want that new couch” fund or a “Hey, let’s take a spur of the moment vacation” fund. Those are wants, not needs. To deal with these situations create a monthly budget or a more involved long-term savings plan.
When should I start an emergency fund?
It’s the first step…all other issues are secondary. There simply has to be funds available to manage a crisis or all other financial goals will fail.
The emergency fund serves as the basic building block, the foundation of any sound financial plan. All other goals like paying off debt, saving for retirement or funding the kid’s college can come later. Once the money is saved to deal with a crisis, the funding of these other goals tends to pick up steam because you are no longer going into debt to handle the emergencies.
How much should I save in the emergency fund?
It depends on where you are in the financial journey.
In the beginning you should have at least $1,000-$2,000 saved. This amount provides enough of a cushion to cover most emergencies. Once this amount is accumulated, you can move on and aggressively pay down all non-mortgage debt.
Once the non-mortgage debt is gone, it’s best to increase the emergency fund to 3-6 months of expenses. Any less than three months and there is a risk of not being funded enough should multiple emergencies hit in a close time span (and at some point they will). Any more than six months and the risk is having too much money locked into a low interest paying asset, instead of funding other investments (like the stock market) that would yield higher returns.
We capped our emergency fund when we reached 3 months of total expenses. At that point we discontinued growing it and only ever fund it now to replenish what we’ve taken out for an emergency. We felt three months was adequate for our family because we have other investments to draw on to fund any crisis that might extend beyond three months. For someone with no other investments to draw on, I would recommend funding it to the 6 month limit.
How can I quickly build my fund?
This may seem odd, but in order to build our emergency fund we started doing a monthly budget and sticking to it with discipline and focus. The impact of our budget is that it helped us to spend less, which in turn caused our savings rate to skyrocket. Honestly, it was no trouble accumulating three months of expenses for our fund once we started doing a budget.
Other ways to build the emergency fund quickly might be to sell some personal items, get a part-time job for a short time frame or cut unnecessary household expenditures like cable TV and eating out.
What will this ultimately do for me?
The biggest financial benefit to the emergency fund is that it keeps you from going into debt to solve each crisis. Having the ability to stay out of debt is key to reaching longer-term financial goals.
The biggest personal reward that comes from having an emergency fund is peace of mind. Knowing that major life issues can be handled with the cash I’ve saved causes me to sleep very well at night.
There is no time like the present to get started working on this. Your next emergency might be right around the corner.
Questions: Do you have an emergency fund? How has it helped you? How much do you think a person should save in an emergency fund? What are some other great ways to build an emergency fund?