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
- 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!
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