Emergency Funds 101
Before we get into this whole emergency fund article I have something to admit. I used to think they weren’t important. In fact I didn’t have one (or even try to build one) for many years. I figured I had plenty of available credit (first on credit cards and later in home equity lines) and that I was better off investing my money instead.
Even just reading that paragraph makes me want to shake my younger self. I now am a big believer in emergency funds. This is not because I had some huge emergency I was unprepared for but because life changed (as it is apt to do) and the security I get from my emergency fund makes it easier for me to sleep at night.
source: Tax Credits
What is an Emergency Fund?
An Emergency Fund is simply money that’s set aside for an emergency. The money should be in cash (not invested) and easily accessible. I use an online savings account for mine. Yes you could potentially earn more if the money was invested but that is not the purpose of this account. The purpose is to have cash on hand in case you need it – something that cannot be guaranteed if it is invested. You should have other money that is invested – but not your emergency fund.
Why Have an Emergency Fund?
Why should you have an Emergency Fund? This is so you have cash on hand to deal with life’s emergencies. Couldn’t you just use a credit card or line of credit? Well this would probably work o.k. for small short term emergencies but what if you were out of work for 6 months? Using credit only compounds the problem because you are adding interest charges each month. Also if you have a big emergency you could end up maxing out your credit and then being out of luck. An emergency fund will keep you out of this vicious cycle.
When to Use it
What is an “Emergency”? Well this is something to decide before you start your account – so you’ll know when you can use it or not. My emergency fund is only for large and unforeseeable emergencies (like long term unemployment). I don’t use my emergency fund for things like car repairs because I know that eventually (or sooner) cars need repairs – so I’ve budgeted for it. You may decide differently but it’s best to decide beforehand what it will be used for (or else you’ll find many “emergencies” cropping up).
How Much to Put in
This is the million dollar question. Many experts disagree (or even change their minds) about how much is enough. Some start as low as $500-$1,000 while others suggest a year’s worth of expenses. I think that how big your fund is should depend on your circumstance. Is your income variable or steady? Are layoffs coming soon in your company or is it hiring new employees? Are your expenses low or high? All these questions factor into how big your fund should be. My current fund level is based on the “sleep at night” test – it’s big enough that it lets me sleep well at night. Very scientific I know. You will come up with your own number but that number can change over time (and circumstance). I think having a fund in the first place is the biggest step.
How to Start an Emergency Fund
If you’re just starting your emergency fund it can be daunting. Looking at a big dollar amount to save up can feel so hard that you put off even starting. I think the best way to start is $1 at a time. First look over your budget (you have a budget right? If not this is step 1) and decide how much you can put toward the fund each month and automate it.
Next, look for extra money to boost the account. Can you take a part-time job? Can you open some credit cards for some extra cash? (I hear Madison’s going to get over $3,000 from her credit card spree – that would be a nice boost to an emergency fund.) Decide that a percentage of any unexpected money (overtime, gifts, refunds, etc.) will go to the emergency fund.
When I was building mine I created a simple graph so I could see it growing each month. I found this small act to be very motivating – I really wanted to see that graph go higher. It also helped me not get discouraged on the months where I could only add a little (I could see it was still moving up over time). Find what motivates you and don’t give up. Depending on how high you’re aiming for this could take a while.
Do you have an emergency fund? What were your best tips for building one up?
I think many people lose out on a lot of interest earnings by having a big emergency fund. The way I get around not having an emergency fund is by having a ROTH IRA. All my contributions can be withdrawn tax free at any time. This way my emergency fund is actually helping build my retirement as opposed to making 0.5% in a savings account (if you are lucky). Sure, it takes a couple of days to get access to the cash because I have to sell my mutual fund and then transfer to my bank account, so I keep a little bit of cash in the bank and can use credit cards for the few days until my ROTH IRA contributions are taken out.
This is one way to go. I personally don’t invest my emergency fund because I’d rather have the security of it being there when I need it (many lost jobs at the same time the market crashed). If you’re comfortable with this posibility it is a fine way to go.
I am going to try this again, as my last post did not get posted for some reason. There are 100 ways to skin a cat and what works for you might not work for other people. I personally don’t need money sitting there, doing nothing, just in case I need it, in liquid form, so I can sleep at night. I sleep at night knowing I have insurance, can handle anything that can possibly be thrown my way, and have a good overall financial plan. I am not trying to say you are wrong in your approach, but it is definitely not the only way to skin this cat.
First off I I would bring up the over use of “Emergency Fund.” A true Emergency Fund is a fund of excess cash that is utilized for immediate short term requirements when unexpected expenses come up when no other cheap means of payment can be had. An emergency fund is used to pay your home insurance when it is due because you annualized your budget, and it is due in August. A loss of a job, a sudden illness, etc. all things people call “emergencies” are actually a “Change in Circumstances.” Change in circumstances can be planned for and may take a week or a month, but you can get them planned for and change your finances to handle it. When I was unemployed for over a year, that was not an emergency, that was a change in my earning capacity, and thus different measures and compensating controls in my portfolio and finances went into effect. Notice the word choices, they are all planned.
I am not worried about emergencies, as I have lots of credit limit cap on my credit card. If I need new tires today, I pay with my card, and I pay it off at the end of the month. I am worried about change in circumstances, which fundamentally change my financial landscape, and no amount of cash is going to help that.
Now back to my original statement, there are 100 ways to skin a cat. I have access to cheap, plentiful credit (which pays me back % each year). I pay my credit cards off every month. I have a good deal of investments (property, stocks, bonds, etc.). I have 15-20k in a “slush fund” to handle months when things need to be floated. I don’t live paycheck to paycheck as I am an old fart. A good example came up yesterday, my insurance company just told me that they put my two houses (mine and rental) and my two cars (mine and my teen son’s 20 year old pickup) on the same payment schedule, and oh yeah, they are due by the end of September. That was $2800 I was not expecting to pay. Guess what, credit card here I go, get $28 back at the end of the year, and that comes out of the slush fund next month when I get the bill. When my slush fund gets too much in it, I invest it elsewhere.
I like the idea of the Roth – but I am not touching my roth at the moment since I am unemployed, and am trying to limit my expenses, and only going to go there if things are very dire.
Again – I am not trying to rail on you, I am just trying to state that there is alternative viewpoints on this topic.
I agree with you on on much of this. Sounds like your “slush fund” and available credit is working for you. Since this passes the “sleep at night” test for you I think it is great.
My husband and I both work full time We both insure our income for the eventuality of long term illness or loss of employment. We need 2 months only emergency fund and then the income insurance takes over 75% of last income. This lasts for up to 2 years.
Adrienne your topic is very interesting and informative especially if we are starting our financial planning. The main purpose of emergency fund is to extra money to buy for foods, pay the bills & etc., in case you or your wife loses a job or monthly income.
According to most experts the amount of emergency fund should be equivalent to 3 months to 6 months of your family expenditure. In our case because we have 2 kids, we need at least 6 months of our living expenses for our emergency fund.
First we started saving small amount of money until we set aside $500 per month for emegency fund purposes only.