One of the major components of being financially fit is having an emergency fund. This raises questions like what is emergency fund for. Having a lump sum of cash in the bank will give you financial peace of mind and set you apart from the majority of people who are living paycheck to paycheck.
The vast majority of people would be up a creek without a paddle if they lost their jobs tomorrow. Many wouldn’t even be able to make it to the end of the month.
An emergency fund is a solution to this huge financial problem. Along with following a budget and paying off debt, having an emergency fund is one of the keys to taking control of your finances.
What is Emergency fund for? Importance
Picture this: You walk into work tomorrow, and your boss calls you into his office. “Jeremy, the company has had a rough year, and we’re being forced to downsize. “I’m sorry, but your position will be eliminated at the end of this week.”
If you’re like most people, that would be devastating. How will I pay my bills? Will I be able to put food on the table?
An emergency fund is important. It gives you a buffer so that you have room to breathe if you lose your primary source of income.
An emergency fund is also beneficial when you have those large and unexpected expenses – things like if you have to replace your roof and your insurance company won’t cover it or medical bills (even with insurance, you may owe thousands out of pocket.)
How Much Should You Save For an Emergency Fund
Practically all financial advisers agree that you need money in the bank for emergencies. though none agree on a specific amount you should have.
Dave Ramsey recommends 3 to 6 months of expenses. Suzie Orman believes you should have 8 months’ worth of expenses in the bank. (She refers to it as “safe and sound money”).
I think 3 months is a little lean, and 8 months may be a bit much. 6 months is a good midpoint, and that is what I am working to have in savings. The key question is how long it would take you to find another job. Take that amount of time and double it. With the economy the way it is right now, the job market is extremely unpredictable.
The industry you work in is also a big factor. Those with a limited field of expertise will need a bigger cushion than someone who can work in a wide range of fields.
The bottom line is this: your emergency fund should be large enough to carry you through any period of unemployment.
How To Save For an Emergency Fund
First things first. You need to pay off all your debt (except for your mortgage) before you start packing away thousands of dollars into savings. It’s a great idea to do a mini-emergency fund of $1,000 first (a la Dave Ramsey). But after that, it’s all about paying off debt.
If you followed a structured plan to pay off your debt, then it shouldn’t be any problem to redirect that extra income toward a savings account.
Building up your savings will require as much discipline as paying off debt, if not more. You need to contribute as much as you can, month after month. It will take some time to save several months’ worth of expenses.
Seeing all of that money in the bank, it can be tempting to slack off. But don’t do it! You have to be laser-focused, just like you were when paying off debt.
Also read: how to make a budget plan
Where To Keep Your Emergency Funds
An important thing to consider is where to keep your emergency fund. (Hint: the Bank of Mattress isn’t a great choice.)
You need an account where there is zero chance that you could lose the money. That means you don’t go and put this in an investment account. The prospect of earning 8% on the money may sound good, but what happens when you need to use the money and the market happens to be down 20% from when you put the money in?
Well, then, CDs may sound like a good idea. They’re safe and allow you to earn interest on your money. The problem is, they also lock up your money. Your emergency fund becomes illiquid, defeating the emergency fund’s purpose.
A great place for an emergency fund is a high-yield savings account or a money market account that is FDIC-insured. Some credit unions are paying great rates on accounts. My checking account is currently earning 2.96%.
Stupid Emergency Funds Strategies
Okay, so I also want to talk about some stupid strategies I’ve heard from people. These are terrible ideas. I mean, terrible.
One strategy I’ve heard some financial advisers offer is to use a Roth IRA as your emergency fund. The reason they say this is a great idea is that you can withdraw your contributions (but not the earnings) without penalty.
There are two problems with this. First, this violates one of the rules above—this money needs to be 100% safe. Even low-risk investments can decrease in value. Second, IRA contributions are limited to $5,000 per year in total. So if you contribute $5,000 and withdraw $3,000 for an emergency, you can’t repay it. You’ve already hit the $5,000 limit.
I’ve also seen people say that you should just use your most significant asset as a lifeline—your home. They say if you need money for an emergency, just get a home equity line of credit. Well, what happens if you lose your job and there’s no equity in your house? What if the bank takes 60 days to approve the HELOC? What if they don’t support the line at all?
And the absolute worst advice I’ve seen is to just use credit cards. Hello? Seriously?
One other no-no is combining your emergency fund and your play money. They say, “don’t dwell on the negative.” Save for something positive, like a boat or a vacation. If trouble strikes, use the money for an emergency. If you never need it, then go to Hawaii!
Then, it’s inevitable that you would break your leg in Hawaii and come back to $5,000 in medical bills and be out of work for 6 weeks. Just use your emergency fund! What? Did you use it to go to Hawaii? Whoops…
Emergency Funds Calculator
To make all of this simpler, you can use an emergency fund calculator to get an idea of exactly how much you need for your emergency fund.
Bankrate has a calculator that covers most of the major items.