When life throws you a financial curveball, there is only one thing separating you from being able to sleep easily or lying awake all night worrying. That thing is an emergency fund.
Emergencies are part of life. In life, anything can happen. You could be in a car accident, lose your job, a pipe could burst, or end up in the hospital after tripping while playing with your dog. Life is unpredictable and emergencies will happen. The only thing you can do is be prepared for the unexpected as well as you can.
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What is an Emergency Fund?
First of all, what do you consider a real emergency? Seeing cheap flights to Hawaii, someone stealing your lunch from the office fridge, or having to buy a set of new tires for your car are not emergencies. Those are wants, inconveniences, and things you should have budgeted and saved up for.
Actual emergencies are unavoidable situations. Your pet getting seriously ill. One of your tires gets a blowout. Or you suddenly get laid off are real emergencies.
An emergency fund is money set aside that is readily available for life’s unforeseen speed bumps. Before you dip into your emergency savings, ask yourself if you absolutely need to take out the money. No one wants to be stuck without options. An emergency fund provides you options until you can get back on track.
How Much To Save in an Emergency Fund
Everyone knows they should have some money set aside for emergencies. But what most people don’t know is how much they should save in their emergency fund. To be honest, there is no right or wrong answer to this question. What is adequate to one person might seem too much or too little to someone else.
Most personal finance experts recommend keeping 3 to 6 months’ worth of expenses in an emergency fund as a general rule of thumb.
Dave Ramsey for example, says if you are starting out, you should save $1,000 in your starter emergency fund. Then once you are out of debt, move to keep three to six months of expenses in a fully-funded emergency fund.
In their paper Rules of Thumb in Household Savings Decisions, economists Emily Gallagher and Jorge Sabat found that an average low-income household of four that earns about $30,000 a year should set aside $2,467 or about 1 month of income.
Others might feel more comfortable having a year’s worth of expenses stashed away. It is always better to have some money in a bank account earning interest than going into debt and paying interest.
Factors That Affect How Much To Keep in an Emergency Fund
The “personal” in personal finance means that is no one size fits all for everyone. You will have to look at your situation to see where you stand.
Saving three months’ worth of expenses might be enough if you
- have a stable, easily replaced, or in-demand job
- don’t have any major health problems
- don’t have pets, kids, or other people depending on you
- have a reliable car or use public transportation
- have minimal debt
- have a newer, paid-off house
- have low deductibles on your health and auto insurance
- are single or can move in with family
Putting aside six months of expenses should cover you if you
- have a partner with a steady income
- own an older home or have a mortgage
- are a renter
- have higher deductibles on your health insurance
- have medical conditions, or have a risky job or hobbies
- have dependents or pets
- have credit card, personal, or student loan debt
- have a job that is harder to replace or might require relocation
Consider saving twelve months of expenses if you
- earn an irregular income or are paid on commission
- are the sole earner in a household with dependents or have a stay-at-home spouse
The amount you need to save is determined by the stability of your income, who may be able to step in to help with any surprises, and the number of people who are depending on you. If you have a mix of factors that put you at the higher end of the recommendation, you may want to save a bit more.
Calculate How Much You Will Need for an Emergency
The financial gurus’ recommendation of three to six months assumes the worst-case scenario where one loses their job. After job loss, consider what other major expenses you may experience and how much you’d need to cover them.
Estimating the amount of money to put into your emergency fund is simple enough if you are tracking everything. You are tracking your spending, right? If not, personal finance apps like Mint and Personal Capital can make this easy.
The quick way would be to total up all the important household expenses that you must pay every month, such as:
- Housing (rent or mortgage)
- Transportation (gas, Uber, or public transportation passes)
- Healthcare (medical insurance premiums, copays, and prescription drugs)
- Debt (student loans, credit cards, personal loans, car loan)
- Insurance (auto, home, or renters)
- Utilities (power, water, gas, phone, and internet bills)
Be sure to include any payments that you make semi-annually. Exclude from your expenses anything that can be cut out in dire situations. This may include entertainment, dining out, vacations, and any splurges such as junk food, Netflix, Amazon, or Steam subscriptions, and non-essential purchases.
Where to Keep Your Rainy Day Fund
Your emergency fund should be placed somewhere that earns you interest so you are getting some return for the money that is sitting in the account.
You will want it in a separate account from your regular savings or checking account so you aren’t tempted to tap into it for “fake” emergencies like a 50% off sale at the shoe store.
To get the highest interest rate, consider an online savings or money market account. Some people might prefer a money market account such Ally Bank’s Money Market Account, which comes with an ATM/debit card and check writing privileges for quick access in an emergency.
I keep my emergency fund in an online saving account for the higher interest. Although I don’t have instant access to cash with an online account, I do have credit cards with high enough limits that can cover most non-cash emergencies. I can put the charge on a credit card and transfer over money to my checking account to pay off the card at the end of the month. Note that I’m not using a credit card in place of an emergency fund. I’m using the card as a temporary bridge until the ACH transfer is completed.
One place where you would want to avoid putting your money is in the stock market. A well-funded emergency fund means you won’t have to sell investments in an emergency. You are more likely to lose your job in a downturn. At the same time, your investments will likely take a hit too for a double whammy.
How does your emergency fund compare to financial advisors’ recommendation of three to six months? That may sound like a lot, but keep in mind that it is 3 to 6 months of expenses, not income. And the amount is not expenses during normal times, but with all the extraneous purchases omitted.
If your emergency savings aren’t where you want them to be, make sure to read my post on how you can trick yourself into saving money for any of your goals without feeling like you are depriving yourself.
With an emergency fund, you on your way to taking control of your money and having peace of mind from whatever life throws at you. As seen from the year-long pandemic, anything can happen.
How prepared are you for an emergency? What were some situations where you needed to access your emergency savings?