An emergency fund is a safety net many people turn to on different occasions throughout their lives. A good financial plan always includes one. The presence of an emergency fund can be the difference between a financial hiccup and a financial disaster. Don’t start investing until you’ve set aside a buffer that gives you a degree of comfort about handling the curve balls life can throw at you.
One of the things we so often insist on telling ourselves is: “It’ll never happen to me.” Whether it’s a health crisis, legal battle, a home fire or a natural disaster, these are all things that just happen to other people and we witness on the news. The truth is, every family experiences unexpected challenges - from annoying car breakdowns to more costly mistakes and all the way to catastrophic events.
The purpose of an emergency fund is to save you from having to dip into long-term investments for short-term crises. It’s like having an insurance policy for your nest egg. (For more, see: Why You Absolutely Need an Emergency Fund.)
Structuring an Emergency Fund
There are several ways to structure an emergency fund, but you must be resolute that these funds are not to be touched for anything except a true emergency. An emergency does not include a vacation you feel you really need or a new device you simply must have. This money should be accessible reasonably quickly. It should be kept in a separate savings or money market account away from regular checking account. It’s important to have that “wall of separation” so it doesn’t get cut into during leaner months. It should not, however, be tied up in investment accounts that you can’t access without penalty if you need to.
How Much Is Enough?
How much money should you have in an emergency fund? There is not one absolute answer to that question. It varies depending on factors in each individual’s situation. For many households, three months of regular expenses would be a good emergency fund. For someone with a higher and very secure income, less may be adequate. For someone who is self employed or whose employment is less certain, three months may not be enough. The key question is how much savings will it take you until you are confidently ready (within reason) for any financially challenging event that might come along?
On the other hand, bear in mind that there is an opposite pitfall that people can fall into. Fear drives some to keep building their emergency fund beyond what is really necessary. The problem with this is that keeping these funds readily accessible means they are not going to be able to gain much interest. Having too much held in cash because of fear means that you are not realizing the growth that you might through wise investment. The goal is to find the right balance.
How to Build an Emergency Fund
Here are some simple ways to build an emergency fund:
- Treat it like a monthly bill. Even a little set aside each month will soon add up to the amount you need in reserve.
- Add any additional income you receive that is outside your normal budget. Some examples might include a favorable tax return, an inheritance, a bonus from your employer or a gift from a friend.
- Sell some stuff that’s just cluttering up the house. Have a yard sale, or list some items on eBay. Don’t spend the proceeds - add them to your emergency fund.
- Make some extra money on the side. Not many people enjoy working two jobs, but if it’s just for a short time while you build that emergency fund, there are many things you could probably do.
If you don’t have an emergency fund, make building one a priority. Don’t delay. (For more, see: How to Build an Emergency Fund.)