If you've ever listened to a personal finance radio show, you might have noticed that the financial experts who answer callers' questions almost always ask about the caller's emergency funds before offering any advice. So what is an emergency fund, and why is it so important?
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The Best Kind of Insurance

An emergency fund is the best kind of insurance you can have to cover many of life's unexpected expenses. But instead of purchasing this "insurance" from an insurance company, you "purchase" it from yourself by paying monthly "premiums" into a special savings account that you don't withdraw money from – ever– unless you are faced with a true financial emergency.

When you do need the money, no one has to approve your insurance "claims." As long as you keep the money somewhere safe and liquid, like a savings account, you'll be able to access it as soon as you need it. (Learn to plan ahead in 6 Months to a Better Budget.)

How Much Should You Save?

First, you'll need to calculate your monthly living expenses. Then, depending on the financial expert you choose to listen to, you should decide to save anywhere from three to 24 months' worth of living expenses in your emergency fund. Within that guideline, there's even more room for interpretation. Some people say you just need a certain number of months' worth of basic living expenses – to cover things like your rent or mortgage, utility bills and groceries – while others advocate having enough to keep living life as usual, to take the pressure off the situation and keep up your spirits.

Why does the amount vary so much? It depends on factors such as your personal risk tolerance and what other financial safety nets you have. (It may be time to reassess your risk tolerance. Read Are You Living Too Close to the Edge? to find out more.)

How Wide is Your Safety Net?

You might feel comfortable having less in your emergency fund if, for example, you have a disability insurance policy that will start paying you a significant percentage of your salary after an unforeseen injury has made you unable to work for more than 90 days. The same might apply if you have a life insurance policy on an income-earning spouse or if you have a solid health insurance policy. These policies would provide you with some level of financial assistance in the event of certain catastrophes.

Some people might also feel comfortable relying on emergency assistance from family members. It depends on what kind of relationships you have and how money factors into those relationships. You might have parents who would help you cover a huge, unexpected expense if you took precautions to avoid that expense and are generally responsible with your money. On the other hand, you might not know anyone who isn't broke. Or you might not want to have to ask anyone for a favor or put yourself in a position to owe anyone anything.

However, you can't choose what type of disaster might befall you or when it might happen. There are many things that you might not have insurance for (your dog breaking a hip) or that insurance doesn't cover (your car needing a new transmission, your furnace calling it quits in January). A relative who might be willing to lend you money might not actually have money to lend when you need it. (Learn to come out of hard times in 4 Ways to Weather an Economic Storm.)

Credit Cards

Relying on credit cards for emergencies is a bad idea. For one, the bank could lower your credit limit, leaving you with less of a cushion than you expected. And even if that credit is available when you need it, do you really want to suffer the double whammy of an unexpected expense and having to pay interest on it?

When you have an emergency fund, you can lend money to yourself at a fantastic rate – 0% – and pay it back on your own schedule. There are no interest charges, late fees, over-the-limit fees, dings to your credit score or debt collectors to worry about. An emergency fund lets you emerge from a period of financial difficulty with the least possible damage to your financial situation.

Once you've handled the crisis, it's important to replenish your emergency fund. Try not to feel overwhelmed by the total dollar amount you'd like to have in your emergency fund – just start saving a little bit each month and, eventually, you'll get there. (Learn more in The Basics of Financial Responsibility.)

True Emergencies

It's important to be able to distinguish between a true financial emergency and a situation that isn't. Here are some examples of things it is okay to spend your emergency fund on:

  • Making ends meet when you're unemployed
  • Medical and dental emergencies
  • Essential car repairs
  • Critical home repairs
  • Unexpected tax bills
  • Recovering from a natural disaster

The more financially comfortable you are, the more leeway you might be able to give yourself with how you use your emergency fund. If you're a two-car household and one car needs a new alternator, it might make more sense to use your emergency fund to replace the alternator than to force yourself into a cumbersome carpooling schedule.

Here are some examples of things you should not spend your emergency fund on:

  • New clothes
  • Toys
  • Sports playoff tickets
  • That tropical vacation you so deserve
  • A down payment on a home
  • A wedding

The Bottom Line

Ultimately, the best way to be prepared for unexpected expenses is to rely on yourself – and an emergency fund is the best way to do that. That said, it's important to balance saving for emergencies with your other financial priorities, such as paying down high-interest debt and saving for retirement. While very important, an emergency fund is just one component of your overall financial health. (Learn more in Building an Emergency Fund – and check out the opposing point of view in Why Emergency Funds Are a Bad Idea.)