Most of us are familiar with the concept of an emergency fund and why you need one. It is the most fundamental type of savings that you can have, because it is there to provide a cushion against sudden and unexpected financial issues.
Some people are never able to get an emergency fund going. As a result, they often don’t move on to achieve any level of financial independence because they are constantly faced with emergency situations and no funds to deal with them. Others establish emergency funds, but end up draining them for non-emergency purposes.
The best way to avoid that fate is to set up dual savings accounts – an emergency fund, and a budget account that will prevent you from raiding your emergency fund when it is not absolutely necessary.
Set Clear Definitions For An Emergency
The only way to have a successfully functioning emergency fund is if you set very specific definitions as to what constitutes an emergency, and you never dip into the account unless the crisis fits neatly within the definition.
Everyone’s concept of an emergency fund tends to be a little bit different, but I think that the key definitions are sudden and unexpected. Sudden, as in an event that seems to come out of nowhere. If it is something that you knew was coming, it does not fit within the definition of sudden, and is not a legitimate emergency.
“Unexpected” is another critical definition. If a financial event is truly unexpected, it means that you had no reason to prepare for it in advance. Anything that you do know beforehand should hardly constitute an emergency.
A job loss, for example, can qualify as an emergency because it is sudden and unexpected. Replacing all four tires on your car doesn’t fit either definition, because it is a maintenance item that you knew about long in advance.
An Emergency Fund Should Never Be A General Use Bank Account
An emergency fund should be an account that is special and set apart from the rest of your finances. If you are using your emergency fund simply to cover monthly budget shortfalls, that is not a true emergency fund. It is important to maintain that distinction, otherwise an emergency fund is simply not an emergency fund.
Your checking and savings accounts should represent your general use bank accounts. That means they are available to cover your normal budget, as well as any expected expenses. If there is an imbalance here – that is, an insufficient amount of money in these accounts to cover your expenses – then you have a structural financial problem. The problem could either be insufficient income, or excessive spending. An emergency fund will not fix either of those problems, nor should it be expected to.
Set Up A Budget Account To Handle Expected Expenses
One of the ways to avoid imbalances in your budget, is set up some sort of budget account. This should be an intermediate level account. It should be more accessible than your emergency fund, but less so than your checking and savings.
While your checking and savings should be available to meet your normal spending budget, and your emergency fund is held for true emergencies, a budget account can function as a halfway type of account.
You won’t use this to pay regular bills, but rather you’ll use it as a an account to pay for anticipated expenses. This will largely include maintenance costs and near-term spending priorities. Knowing these expenses are coming up, a budget account will enable you to put money aside in anticipation of meeting them.
Maintenance costs that you should be funding through your budget account can include:
- Expected car repair expenses. If for example you expect to average $1,000 per year for car repairs bills, you should be putting away about $80-$90 per month to budget for this.
- A roof replacement that’s expected in five years – if the cost will be $6,000, you might want to begin saving about $100 per month in anticipation. The 60 months between now and then will allow you to save the money you need.
- Your refrigerator is ten years old, and it will cost $1,000 to replace; figuring it will last another two years, you may want to begin saving at least $40 per month ($1,000 divided by 24 months).
Near term spending priorities might include some of the following:
- Saving up money for a family vacation. If you know that you’ll be spending around $3,000 for your vacation, you should be putting $250 into the account each month ($250 X 12 months = $3,000).
- Holiday expenses. You can think of your budget account as being something like a Christmas club account – putting away a certain amount of money in anticipation of heavier expenses at the holidays.
- Your eight year old looks like she may need braces in a few years – you can begin saving for this in your budget account.
Each of these expense types are fully expected, and therefore they are hardly emergencies. You can and should budget for them, and by having a budget account set up you can do just that. If you do it faithfully, you will not need to raid your emergency fund, nor drain your regular checking and savings accounts.
It seems a bit complicated, but can you see the merit of having dedicated accounts to cover different levels of expenses?