An emergency fund is a stash of money set aside to help you cope with unexpected expenses, and yes, you need one. Everyone gets into a bind sometimes where they need a little bit of financial help, and for the smart money savers who have kept their emergency stash safe, it’s possible to survive unexpected financial surprises.
The emergency fund is also an essential financial planning tool as, without one, money to cover emergency expenses has to come out of one’s regular income or it has to be borrowed. Not having an emergency fund has the potential to throw an otherwise organized budget into severe disarray.
So what is it exactly?
An emergency fund is not a regular savings account, it is not an investment, nor is it a sinking fund (one into which you pay regularly to cover a planned expense like a new car or vacation). It is a form of insurance against catastrophes such as severe illness or fire, breakdowns of things like the car or furnace, or a suddenly being fired from a job which leaves you temporarily stranded without income.
In other words, the emergency fund is there to be used in circumstances over which you have no control, and for expenses that you would otherwise have no way of covering. By the way, feeling a strong desire to buy a new entertainment system doesn’t count as an emergency need- just wanted to make that crystal clear.
Insurance Isn’t Enough
Even for those people who go the extra mile to have the most coverage in their insurance policies- it’s important to keep an emergency fund handy. Here are a few examples of insurance policies that may not quite carry you through difficult circumstances.
- Medical Insurance: Even with good medical insurance, there are inevitably some things that could happen that are usually not covered under any medical insurance. Additionally, there are always deductibles associated with medical insurance.
- Homeowners Insurance: More deductibles.
- Disaster Insurance: In the case of a flood, fire, or weather-related disaster, a good insurance policy should pay for all expenses including temporary accommodations. In spite of the security that disaster insurance offers, few insurers will turn up with a check in hand right away. It may be weeks, even months before you see any money from them.
For glitches that inevitably occur with insurance policies and insurance companies, an emergency fund is a lifeboat that can carry you through the rough seas.
Warranties, Murphy’s Law, and Modern Engineering
Murphy’s Law says that something will go wrong with your car the day after the warranty expires, and ditto with the furnace, computer, fridge, washing machine, and every other electronic gadget that you own.
Actually, thanks to modern engineering there is no longer any reason to worry about your electronics breaking as a result of Murphy’s law, electronics are actually made to break right after the warranty expires. So if you have an air conditioner that the company provides a five year warranty on, you can expect it to break down during the sixth year. But I digress.
The main point is that when electronics break it is usually not the most opportune time, such as the air conditioner that breaks in July, or the laptop that breaks during a business trip.
Often, at these inopportune times, when electronics break people end up asking “What are we going to do now.” If you have been putting away an emergency fund, the answer is simple.
When your car suddenly needs a new engine, or your house a new furnace, you will be very glad that you had the foresight to establish an emergency fund.
Sudden Loss of Income
Possibly the most important reason for establishing an emergency fund is to mitigate the problems that result from loss of income. Losing one’s job or otherwise being unable to work not only drastically reduces income, but can likewise increase expenses for things like health insurance.
If you have unemployment or disability insurance that will help a bit, but considering the cost of essentials such as mortgage or rent, utilities, food, and so on, insurance probably won’t cover everything.
Careful planners will have built-in loss-of-income insurance as part of their mortgage and only need to dip into the emergency fund for other expenses. Those who failed to plan ahead will incur the debt.
How Big Should the Fund Be?
The truth is that the more money you have in an emergency fund the more you will have available in case you need it. But considering that you probably have other things that you will want to use your money for, other than stuffing it in the emergency fund, the experts recommend having enough money available to cover at least three months’ worth of living expenses.
Money Doesn’t Grow On Trees- Funding the Emergency Fund
Start small by setting aside a few dollars every week, and once you get accustomed to setting money aside start setting a little bit more aside. Eventually, you can work your way up to the goal of having 3 months worth of money in the bank. Once you reach the goal of 3 months’ worth of money, you can stop feeding the fund unless you want to have a larger pillow in which to fall back on.
Build an Emergency Fund When You’re Already in Debt
Are you financially prepared for an emergency? More than a quarter of all Americans have no savings stored up, and nearly three-quarters lack enough savings to cover six months of expenses.
Being financially unprepared for an emergency leaves you vulnerable in the event of a job loss, a sudden medical or car expense, or a natural disaster. The result can leave you struggling to pay for short-term necessities while damaging your long-term credit. Your best insurance against this scenario is building an emergency fund to prepare for the unexpected.
Set a Savings Goal
How big should your emergency fund be? For many years, experts recommended you save enough to cover three to six months of lost income. But in a post-recession economy, the National Foundation for Credit Counseling advises you save enough to handle nine to 12 months of expenses. This can buy you time in case you need to look for work while covering rent, insurance, credit card payments, and other bills.
On a tight budget, saving up the equivalent of a year’s income may seem daunting. In this situation, experts like financial writer Michele Lerner recommend setting aside a more manageable amount per month, such as $100 or 10 percent of your paycheck.
If necessary, you can finance this with measures such as adjusting your tax withholdings, doing part-time work, selling services, holding yard sales, or renting out a room or vehicle. To automate your budgeting routine, you can arrange to directly deposit your allocated monthly amount into a savings account.
Cover Your Debts
If you have debt, you may be able to grow your emergency fund faster by paying down some of what you owe first. High balances and interest on your credit cards and loans can eat up the money you could otherwise be putting into your savings.
Financial expert Dave Ramsey recommends that after you establish an initial emergency fund of $1,000, you should begin paying off your non-mortgage debts, starting with your lowest balance first. The resulting decrease in your monthly payments will give you extra money you can then put toward increasing your emergency savings fund.
If you’re owed money via a structured settlement, consider inquiring with a company like J.G. Wentworth to sell your future settlement payments for a lump sum now. That money could then be used to pay down your debt and build your emergency fund.
Increase Your Savings
After you’ve paid down some of your debt, you can continue growing your emergency fund to the recommended level. This can then become a foundation for building your lifelong savings. Fidelity Investments recommends you save at least eight times your ending salary to ensure you don’t outlive your savings.
As a rule of thumb, for most people, this amounts to saving 10 to 15 percent of your income, with appropriate adjustments based on factors such as age, spending, and investments.