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?
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{ 12 comments… read them below or add one }
I have a budget for expected expenses as well as a true emergency fund–you’re right, they are different!
I don’t set up separate accounts, though. Too much hassle, and I can trust myself not to blow through money earmarked for something else.
I have to disagree with one thing, otherwise, everything looks good. Be careful when using the words “always” or “never.” You state that “emergency funds should never be a general use bank account.” I have never set up a separate account for emergencies and it has worked out well for me. I can understand the benefit of separating the accounts at lower income levels and tighter budgets, but I would not say “never.”
Great post! It’s really necessary to work out a budget instead of using money set aside for emergency. Good points on how to put up a budget for future, expected expenses.
Great breakdown of the emergency fund. I totally get what you’re saying: if you commingle funds you’re far more likely to spend money that should have been saved for emergencies or opportunities. We’re off to Six Flags on Saturday and are using vacation fund money to ride roller coasters!
Great post. Although replacing all four tires can be an emergency if you drove over tacks or something on the road (okay, that’s extremely unlikely, but I have had to replace two at once due to damage).
How would you classify something that was sudden but expected? Something you were preparing for but happens before you were ready? A couple months ago, I found myself in the dentist chair in extreme pain from a tooth that I had been saving up to get fixed.
Hi Edward – I’d say that’s a contingency expense that became an emergency! Timing does play a role with emergencies. A major car expense that you’ve been budgeting for can become an emergency if suddenly it needs to be fixed today.
We call this account the cash pool savings. It’s like Scrooge McDuck with all of his gold coins in a pool. If you’re saving for new tires that will cost $800 and you need to buy them in 20 months then you’ll save $40/month into this account and have enough to buy tires when the time comes. At the same time you’re saving for your auto insurance renewal that is paid every 6 months. So you save that amount each month in this same account. Basically everything gets pooled together each month and then you have the cash to buy the items when the time comes. Great Post!
Hi Casey – That makes perfect sense. You’re budgeting for known expenses, but keeping it simple.
yeah it’s really simplified everything. We have our monthly cash flow plan and under our savings category we just have 1 line item called “cash pool savings.” On a separate form we have listed out everything from Christmas to vacation to vehicle replacement and how much we’re saving each month for each of those. Total up that column and put that total in the space on our monthly cash flow plan. Maybe takes a few extra minutes (literally) to make sure that we take care of anything that may come up without needing to tap our emergency account. No surprises here!
Great distinction here between true emergencies and expected but irregular expenses. It’s so important to understand the difference and have cash set aside for each. We have multiple savings accounts earmarked for different purposes such as travel, car maintenance, etc. All the kinds of things you mentioned above. It makes the management of spending for these things so much easier and protects the rest of our budget from getting out of whack. Really an invaluable tool.
Hi Matt – Only problem is that it can lead to too many accounts. It might be better to have one budget account to cover known expenses and one emergency fund that you don’t touch otherwise.
I certainly think you can go either way. All of ours are with one bank (Ally) and it’s basically the same as managing one account. We just like having them separate so we can understand a little better how we’re budgeting for each. I can certainly see why some people would prefer having just one though, and I do think there’s a risk with making things too complicated. Hasn’t been an issue for us though.
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