Most people have heard of the concept of an emergency fund. In fact, I even wrote about creating a $500 cushion in your checking account with the thought of an emergency fund (EF) in mind. Here were my thoughts about the connection between this cushion and an EF:
Let me first say that I believe that every healthy financial household will include an emergency savings account with at least 9 to 12 months of living expenses. If one is still in debt, I usually recommend having about $2,500 in emergency savings until the debt is paid off (then boost that up to 9 months). However, many people are not in a situation to make that a reality. So, this should be the first step toward financial freedom.
The point of this emergency fund so you can have money stashed away when something unexpected comes up. If you are not financially prepared for emergencies, then you may be forced to rely on high-interest credit cards, or tap into your retirement savings in order to get by.
So, this is why I recommend having about 9 to 12 months worth of living expenses saved up for emergencies. I would suggest having the money in an account that’s pretty liquid (easy to convert to cash or write a check from), so you can have easy access to it if and when an emergency hits. You can also shop around to find the best CD rates and possibly put your emergency fund in the one with the best rate.
A Common Argument Against An Emergency Fund
There are some who believe that the emergency fund is overrated. They will tell you that you are better off plowing all of your money into investments and putting any emergency purchases on your credit card.
The logic here is that instead of earning 2% interest in a high-interest savings account while you wait for an emergency to come, you can earn a lot more if you invest the money instead. The difference in interest income would be more than enough to cover the interest paid on your credit card.
The Problem With Investing In Place Of An Emergency Fund
First, you would have to be able to calculate the difference between the rate you would earn from your investments and your savings account. No problem, right? It’s pretty easy to figure out how much your savings account would pay you – just go to your bank’s website.
But how about your investments? If it’s anything more than a CD or Money Market account, you can’t be sure. So, you don’t know what the difference between these accounts will be.
Next, you will need to know how much interest your credit card will charge you, how much the amount would be, and how long you will take to pay it off. Estimating the interest rate is pretty easy – if you have good credit and your bank is not about to go under, just use your current rate.
But, how can you possibly know how much you will borrow and how long it will take to pay it back? If our “emergencies” came with that much detail beforehand, I probably wouldn’t be writing this article!
So, we don’t know how much we will earn from our investments, and we can’t predict how much our emergency will cost or how long it will take to pay off.
That situation sounds much too unpredictable for me!
Why You Need An Emergency Fund
- Because life is unpredictable, and many of those surprises come with a price tag!
- Having an emergency fund will help you to avoid running up your credit card when something unexpected comes up.
- It will also protect you from having to sell your possessions at a loss.
- It will protect you from raiding your retirement accounts
- Save you from having to take out payday loans
- You will go a long way from removing a common source of stress (financial insecurity). Find out what the bible says about being satisfied and content!
Many Common Emergencies Are Related To:
- Losing a job/reduced income
- Huge medical bills
- Major car repair
- Anything else that takes money to deal with and you didn’t see it coming
How Much Should I Save For An Emergency?
I recommend doing this in three stages:
First, create that $500 cushion in your checking account that I talked about earlier. In the article that I linked to, there are a number of tips to get you to that goal fairly quickly.
Second, if you are still in debt, I would recommend saving 1 month worth of living expenses. This is on top of the $500 cushion. Once you hit this goal, plow all of your extra money into paying off your debt. Be sure to cut all necessary expenses as well.
Lastly, once you are COMPLETELY debt free, bump this up to about a year worth of living expenses. Of course, if you have irregular income – this is especially true for artists/musicians and small business owners – then you may want to extend this even further.
What Isn’t An Emergency?
For many of us saving this much money will be a new experience. We may be tempted to spend our EF and a few “non-emergencies”. Here are a few guidelines:
Do not use this fund to save for any future purchase, such as:
- Your Carribbean cruise
- New wardrobe
- Big screen TV before the Superbowl
- New car
- Down payment for a house
- Tuition
- Investing in a “sure thing”
- Any other planned purchase
These are not emergencies!!!
Setting up an emergency fund and getting out of debt should be at the top of most of our lists. This will allow us to have the financial stability to handle shocks and the freedom to choose an unconventional path!
Reader Questions
Do you have an emergency fund? How much?
Are you currently in debt? If so, do you still save?
Have you ever had to face an emergency with nothing but credit cards?
photo credit: gadgets.co.uk
I have an emergency fund though I never kept in on a Bank rather I keep it in the safest place. I guess it’s more idealistic that you keep your emergency fund with you ’cause you can hurriedly get some whenever there’s an emergency money call.
I keep my emergency fund split up. I currently have 4 months expenses in cash, and 3 months expenses in company stock through my ESPP. I also treat my Roth as my back up emergency fund which I would not want to touch unless a HUGE emergency. That has another 7 months work of expenses. I’m young so no where near 59 1/2 so the 401k and Rollover IRA are untouchable.
I have an emergency fund which is equivalent to a years worth of my income. I know it is a bit more however I really feel comfortable with that amount of cash in the bank.
Apart from the fund I have investments in a lot of short term ETF’s which I are liquid enough to qualify as emergency fund.
I totally agree with you on the EF. However it doesn’t have totie up a significant amount of money if you are not comfortable with that. In that case, maybe a 3 months salary worth can be held in your EF as a first line of defense while keeping an empty line of credit as a second line of defense in case things get worse.
Yeah, I tend to be very conservative when it comes to being prepared. But, you are right, it doesn’t have to be 1 year for everyone. However, I do think that the decision needs to be based on more than just fear of tying that much money up – it needs to be well thought out and calculated.
Thanks for the comment…of course Akismet didn’t like it.
I think EVERYONE needs an emergency fund. How much you need is up to you. Some people can adjust their entire lifestyle if something comes up and all they may need is 3 months pay while others want to still live comfortably and may need a 6month -1 year cushion.
Very good point about being able to adjust your life and keep a lower emergency fund. Another thing I would suggest is to make those adjustments now in order to build up the EF (they may like it enough to stay in that state).
Thanks for you input!
Great post. Many times efunds are difficult to create because they dont earn much interest and just sit there, waiting for someone to find an “emergency” to use the money for. Trips/christmas/etc is not an emergency.
The money needs to be liquid or else you wont get to it in time to take care of your emergency.
Also, where did you get the code for that yakezie widget?
I agree, it can be tempting to just spend the money if it’s sitting there not earning a lot. Although, the financial peace that you receive from being disciplined is unbeatable!
Here is the link for the Yakezie plugin:
Dave Ramsey calls an emergency fund Murphy’s Repellent. I love that, because Murphy’s Law does seem to kick in much more when you aren’t prepared for it. I’ve seen many people use their credit cards as their emergency funds, but I have never seen the strategy work well. Once the emergency was over, the debt tended to stick around for years afterward.
I’ve never heard the “Murphy’s Repellent” comment before. That is very accurate!
I think many people who rely on credit cards are making a huge mistake! Especially to gain a few extra basis points on your savings.
Khaleef, Great review of why it is important to have an emergency fund and under what circumstances should one increase it. I certainly keep an emergency fund. It is part of my plan to be financial comfortable. I consider it a necessity.
Thanks Shawn,
The writing that I’ve seen against the idea hasn’t been too convincing in my opinion.
I can’t wait until the point when I’m debt free with a fully funded EF!
I think one needs to save a bit more for the emergency fund. I would budget at least 3-4 months of living expenses… you never know when you might be out of a job or need to be on disability etc. (I know that the economy seems to be picking up, but you never know!).
Great post!
Once one is out of debt, I would suggest about a year. At that point, you can probably mix up the liquidity/risk, so you can earn a little more between emergencies.
Our only debt is our home, and we are paying it off as fast as we can.
At our current rate, it will be paid off in 7 years, hopefully sooner.
I do not have 9-12 months of cash in an emergency fund. I have a lump of money set aside that I do not touch if I can help it, but I do not stress if it goes below a certain level. In a absolute true emergency, if we did exhaust our savings, I could tap our home equity line of credit, which would be an absolutely last option, not for tvs or vacations.
I’m glad to hear that you are working toward paying off your home. Many writers will brag about being out of debt, but have a 300k mortgage weighing them down!
One can become too caught up in an EF, and began to put too much trust in it. Anything can happen, so it pays to not stress out if you ever have to use it – that’s what it is there for!
Thanks for the comment!
Back in the day, we had to face emergencies with nothing but credit. We made very little money, and didn’t realize living on credit cards was a bad thing 🙂 now we do have a good sized emergency fund that would certainly cover some of the major problems that are possible out there. We have had to dip into it on occasion and are able to quickly recover, without all the stress or extra expenses that we used to incur.
Hey Jesse, I went through the same thing. That is why I recommend a larger emergency fund than many others. I lost my job without an EF – I was plowing every dime into debt repayment – then I was forced to live off of credit!
Let’s be glad that those days are behind both of us!