I’ve talked a bit about having a good emergency fund, so it’s probably about time I define what an emergency fund is, and maybe more importantly, WHAT IT IS NOT. There are many people who have already defined this, but I want to get a little more detailed and answer the questions; Why, How Much, Where, and For What.
Why should you have a pile of cash that is used exclusively for emergencies? It’s a fair question, because after all, if money is just sitting there, it’s not out working hard for you. And though I believe all money should have a name so you can use it for something productive, this does not mean that you need this money to be active. An emergency fund functions as a brick wall to block out potential financial disasters.
When an emergency arises, you’d better have the cash to take care of it, otherwise that emergency will haunt you for far longer. If you don’t have the cash on hand, you will throw the cost of that emergency on a credit card and NOT pay it off before the end of the billing cycle. You will then pay interest on your emergency, which is just rubbing salt in the wound of having to deal with the emergency in the first place. If you have an emergency fund, your BIG EMERGENCY will become nothing more than a minor inconvenience. You can focus on the emergency at hand instead of wondering how to finance this mess!
Also, having a pile of cash earmarked for those unexpected events that inevitably arise helps you sleep better at night. I know I do! I don’t worry about things that might happen to our house, or one of our cars getting stolen (partly because I buy cheap cars, not new ones), or the long list of things that might cause us financial turmoil. I’ve already go it covered.
So now that we’ve established having money set aside for emergencies is a good idea, how do we figure out how much to save? Dave Ramsey talks about this in his book, The Total Money Makeover (highly recommended, btw. You can read why in my about page). He recommends saving a small emergency fund of $1000 while you are still digging your way out of consumer debt. Then, once you are debt-free (except the house), put away 3 to 6 months of expenses worth of savings for your full emergency fund. My recommendation is very similar: Save $1000 to $2000 while you are still in debt, and save 3 to 6 months worth of income when you are debt free.
My reasoning is that it would really take the wind out of your sails in your debt payoff plan if you had an emergency that cost over $1000 and brought you back into credit card debt because you didn’t have enough saved up. I agree with Dave on the 3 to 6 months of expenses. I recommend 3 months for those with multiple incomes from stable jobs. For those in one-income households, I recommend closer to 6 months.
I recommend coming up with a pared down budget of just your necessities when projecting your expenses. This is because in the event of job loss, you will not keep investing, saving for gifts and vacations (savings buckets), or have any extra money to spare. You will be on a strict budget that is probably much less than your normal monthly budget until your income is back. So if you normally spend $3000 a month on your expenses, savings buckets, debt payoff, etc…Your emergency budget will likely bring you closer to $2500 or $2000 a month. You will halt debt payoff, investing and savings buckets, and just pay for the necessities. I hope that makes sense.
So now that you are saving up an emergency fund for the reasons stated above, where are you going to store this cash? I suggest not keeping it in your checking or savings account where you have immediate access to it. If you do this, you run the risk of tapping your emergency fund for non-emergencies. Now, I know my readers have more self control than that, but I certainly don’t! Here’s my method for stashing away your emergency fund:
- Keep $1000 liquid in your savings account for small emergencies that you need to pay cash for. This allows you immediate access to cold, hard cash if the need ever arises. To be honest, I have yet to run into a situation where cash was required, but it might happen.
- Put the rest of your money in an online money market account. I suggest using someone reputable, such as ING Direct or Ally Bank. I personally have our 3 to 6 month emergency fund stashed away in an ING account. The money takes about 3 days to transfer to our checking account, putting a natural barrier between me and my millio…err…thousands of dollars saved for emergencies. This helps keep me from buying a sweet pair of kicks or a motorcycle with my emergency fund.
Now the real question. When do I get to use this sweet, sweet cash money?! You don’t. Seriously. Stop staring at this pile of cash and drooling over the possibilities. You should probably forget this money even exists. You emergency fund is meant for true emergencies only. A hole in your sock is not an emergency that requires a new wardrobe. A scratch in your car doesn’t mean you can now declare a federal state of emergency and go buy a new car. And yes, even minor car repairs are not an emergency (because you having a car repair fund in your savings buckets for that….right?).
An emergency is a completely unforeseen circumstance that puts you without a necessity. You are required to fix this issue or you will be without something that you actually need. An example of this is that our hot water heater died. This put us without hot water, which is something my wife and I have decided is a necessity. We used our emergency fund to buy a replacement so that we could have hot water again that evening. If you are injured and need medical care that will cost you out of pocket after insurance, that is an emergency. If your cars dies (like, truly dies and is irreparable) and you have no other commute option, that is an emergency.
And when you happen upon an emergency, you should have no guilt or qualms about paying for it with your emergency fund. That is what is there for. This is where the peace of mind really comes into play, and your emergency that could be life altering and put you behind for months becomes nothing more than an annoying pest that you squash with your emergency fund.
Side note: You probably shouldn’t do what my wife and I do, which is start rooting for our appliances to fail. Every time I hear that the refrigerator is leaking something, or the washer or dryer is acting up, I get excited and start looking at replacement appliances like I’m a giddy kid Christmas shopping at the mall. In reality, we should have a savings bucket for appliance replacement! Haha!
Comments: Do you have an emergency fund? Have you ever used your emergency fund for a non-emergency fund? What was your excuse? How much do you have saved up in case of emergencies? And seriously, why can’t woodchucks chuck wood? I have a pile of fence in my backyard that could use chucking right about now…