A wayward rock recently found my windshield and a large crack appeared. It was just one of those unanticipated costs that pop up in life from time to time. After some calling around to find the best price, I had the windshield replaced. Of course, what made this so easy was there were funds set aside for just such an occasion. although a rock cracking my windshield is a mere inconvenience rather than a full-blown emergency, what is important is having an emergency fund for these kinds of unplanned situations.
Why Do I Need an Emergency Fund?
An emergency fund is simply an amount of money set aside for emergencies that may arise. While the exact nature and timing of an emergency is unknown, we can be certain that one will eventually occur, and it is certainly nice to have funds set aside to deal with it quickly and easily. One of the principles of sound financial management is being as prepared as possible for the unexpected. If you don’t have funds set aside, the temptation will be to use credit to meet the need, but when an emergency hits, the last thing you need to do is go into debt.
Sadly, many Americans struggle with funding an account for emergencies. Bankrate.com reported only 38% of Americans could pay for a $1,000 emergency expense with available cash. The remaining 62% would have to borrow the money or cut their spending elsewhere.
Consider your emergency fund as a form of insurance against getting hit with a loss that disrupts the bigger goals you have set for your financial life. Yes, the earnings on this fund will be small, but it’s not an investment, it’s insurance. (For related reading, see: How to Build an Emergency Fund.)
When Should I Fund One?
If you have consumer debt like credit cards and car loans, pay those off as quickly as possible. Taking the time to first set aside a large emergency fund will probably slow that process down significantly. This, in turn, will possibly cost you additional interest charges and push back any debt-free goal you may have in mind.
Even if you have consumer debt, have at least some minimal amount of cash set aside, readily available, for any emergencies that come up. Again, you don’t want to add to your consumer debt at the same time you’re trying to pay it off. How much is a minimal amount? Something in the neighborhood of $1,000 to $2,500 should be sufficient. (For related reading, see: Saving vs. Paying off Debt.)
Where Should I Keep It?
Your emergency fund should be kept separate from your regular operating funds, but still be readily available if needed. In other words, don’t keep it in your checking account, but don’t tie it up somewhere it can’t be quickly accessed. Keeping it too handy can make it too easy to spend on a whim. Having a pizza delivered during the big game on TV isn’t an emergency, neither is a new pair of shoes.
Use an online, FDIC-insured money market account linked to your checking account. By using an online bank, you can get a higher interest rate than a brick and mortar bank. If you need some of the funds, an on-line transfer can be entered and the funds will appear in your checking account the next business day. That is quick enough to handle most emergencies, but slow enough to prevent spur-of-the-moment purchases.
You may also choose to keep your emergency funds in certificates of deposit (CDs) or savings accounts.
Do not invest it in the stock market. Yes, you want higher returns, but the market may crash just as you need the money. At the very time you need it, it may lose half its value. Remember: it is insurance, not an investment! (For more from this author, see: Why Your Roth IRA Should Not Be an Emergency Fund.)
How Much Should I Have in My Emergency Fund?
Here’s where it gets more complicated. Well, not complicated really, just more case-specific. It’s easy to rattle off some theory about having three to six months of expenses. But for most of us, that’s a pretty big range. Expenses should be limited to the essentials and should exclude the discretionary. Here are some examples of each:
It can be tempting to simply say, “I’m conservative, let’s go with six months.” Or to say, “Let’s roll the dice and go for only three months.” But it's more important to examine your personal situation.
1. Do you have multiple streams of income? when I was a full-time freelance CPA, I had multiple clients. If I lost one, I still had the others. The odds of me losing all of them simultaneously was small. While my income might drop, I still had my other client work to fund my expenses while I was looking for new clients. Maybe you have a second job, or a rental property with positive cash flow. these would be multiple streams of income.
2. Is it easy to find a new job in your work field? For example, as a CPA, there are always opportunities available. It may be in a new industry, or with different responsibilities, but generally there are accounting-related jobs available. If, on the other hand, you're an astronaut, it’s reasonable to assume it would take longer to find a new job in your field. (For related reading, see: 9 Different Ways to Find a New Job.)
As you can see, there is no universal answer, and each person who reads this post will answer these questions differently. But when the answers are tallied up, you can get a feel for whether you should have three months, six months or maybe something in between.
Consider the Opportunity Cost of Over-Funding
Everyone likes the idea of having a big wad of cash available when financial trouble arrives, but make no mistake, having an emergency fund costs you money. Those are dollars that could be used to pay off debt or could be invested somewhere else with a higher expected return.
Too large of an emergency fund can slow you down in meeting your financial goals. Imagine you bring home $5,000 per month, and your monthly expenses are $4,500. Now imagine you are starting with zero saved and are going for an emergency fund of six months of expenses:
$4,500 x 6 months = $27,000
At $500 per month, it would take 54 months to save a fully funded emergency fund. That’s four-and-a-half years!
It may be worth it (depending on your exact circumstances), but it may not. You’ll have to answer that question for yourself by finding the balance between the positive benefits of having the funds available and the negative opportunity cost of lost earnings on those dollars.
Peace of Mind
Having an emergency fund is important for all of us. There is peace of mind that comes from knowing a cracked windshield, flat tire, medical bill or broken microwave won’t force you to turn to debt via a credit card to resolve the problem. when you’re prepared for emergencies, you tend to have less of them. Maybe it’s just because they don’t feel like emergencies anymore, simply because you were prepared. There is no one-size-fits-all emergency fund size. By going through the exercises described above, you can each calculate the amount of funds that’s right for you.
(For more from this author, see: A Motivational Strategy to Pay Off Debt.)