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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 [1] 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 [2]

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 [3] 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 [4] 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 [5]? 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 [6] – 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?

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