What is an emergency fund(EF) and why do you need one? An emergency fund is a stash of money that you can easily access in an emergency.
Unless you live with your parents, you already know why you need an emergency fund. There will always be unexpected expenses as we go through life. Your car will break down, your roof will need repair, you will get into an accident, and many other things will go wrong. You can bet that all these things will happen at the least convenient time. If you don’t have the ability to cope with them, you will have to turn to your credit card, cash loan, parents, or perhaps peer to peer lending. These products are useful tools, but you should not have to depend on them in an emergency. These loans should be taken out only after you figure out a way to repay them.
Where to keep your EF?
The emergency fund should be easily accessible. You should be able to withdraw the money in a few days at the most. I like the plain old saving account. The interest rate is rather dismal, but it’s safe and you can get it very quickly.
How much do you need in your EF?
Dave Ramsey suggested starting out with $1,000 in his book,The Total Money Makeover. This is a great start, but most households will need more than $1,000 in their EF. A serious car issue can easily cost more than $1,000 to fix. If you lose your job, you will definitely need more than $1,000 to cushion the blow. I suggest taking a look at your monthly expense and save up at least 3 months of living cost. This should be enough to get you through most financial emergencies. If you have a big life changing event, like retirement or job change, coming up then you would need more in your EF. In this case, I would recommend at least 12 months in EF to be safe.
When to use the EF?
Remember that the emergency fund is for emergencies only. Don’t use it for fun, entertainment, or any luxury purchases. These following cases are not a financial emergency and you shouldn’t touch your EF.
- Wicked comes to town and you have to see it
- The slope is calling and you really need a new snow board
- That hot girl in your office broke up with her boyfriend and you need some cash to take her out. (Well, maybe this one qualifies as an emergency.)
These are the real emergencies.
- Your car broke down and you can’t get to work without it.
- You are sick and need to take some time off from work to recover.
- You are laid off and are looking for a new job.
- Your water heater leaked.
As you can see, the real emergencies will be difficult on your bank account. If you live paycheck to paycheck, then one emergency will create a debt spiral. That’s why you need an emergency fund.
image from Wikipedia