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You are here: Home / Finance Fridays / Quick Guide to the Emergency Fund

Quick Guide to the Emergency Fund

May 12, 2017 MilitaryDollar 2 Comments

There are some basic tenets of personal finance that are recommended for everybody. One of these is the emergency fund. In fact, it’s often recommended as the very first step when people are learning to control their money. This guide explains the basics of an emergency fund: what it is, what to do with it, and how big it should be.

Emergency Funds

What is an Emergency Fund?

Simply put, an emergency fund is money you’ve set aside into an account specifically for the purpose of covering you during a financial emergency. This could be a job loss, an illness, or a major expense (say, major car or home repairs). The point of having an emergency fund is to be able to pay for these things without taking on high interest debt, such as from credit cards or loans.

Because the point is to have the money available in an emergency, you should avoid keeping this money in the same account as other savings or spending money. You don’t want to accidentally spend your emergency fund!

How much money should you keep in an Emergency Fund?

In the beginning, any amount is good. Even the ability to cover a small emergency (like a broken freezer) is worthwhile instead of taking on debt. Eventually, you will want to have several months’ worth of expenses in your emergency fund. The total is up to you, but here are some guidelines.

Many financial experts recommend three to six months of expenses. This is a pretty good standard, but there is some room for variation. If you have an extremely stable job and the chances of losing a paycheck are extremely slim, you might be able to get by with 1-2 months worth of expenses in your emergency fund. Military members are one example of people who are unlikely to be unexpectedly out of work. If that describes you, you still want to make sure you can cover unexpected major expenses.

Conversely, if you are in a job with an irregular paycheck or high volatility, maybe you want six to twelve months of savings. Retirees might also want a larger emergency fund, as they are often relying on investment performance for their income and will want to avoid selling in a down month if they can.

Some experts recommend couples have a larger emergency fund (more than six months) to cover their higher monthly expenses since more people are involved, especially if children are part of the equation. Others will say couples are unlikely to both be out of work at the same time, assuming both work for pay. I say, do what feels right to you.

You might see some financial experts calculate the emergency fund by how much you earn, not by how much you spend. I believe this is a false method. For instance, say you earn $60,000 per year. That’s $5,000 per month. Using income as a guide, a fully funded emergency fund would be $15,000 to $30,000. But maybe you are a super saver and only spend $3,800 each month including taxes. In that case, three to six months of expenses is $11,400-$22,800, not $15,000-$30,000. That’s a much more reasonable goal, in my opinion.

Where to keep your Emergency Fund

The short answer is “someplace safe.”

The long answer is to find a bank you trust that is FDIC insured, is easy to access when you need the money, but is not so easy to access that you take money out for non-emergencies. Preferably the account will also pay interest, and as high of an interest rate as possible. Usually this means a savings account. An online savings account is more likely to have a higher interest rate than your local bank, but shop around.

Personally, I use Capitol One 360 banking. Originally, I set up my account with ING Direct. Capitol One purchased them in 2012 so my account was transferred to Capitol One. I prefer online banks for savings accounts because you can easily move money around online if you need too, but I can’t just go pull the money out on a whim.

Places you should not keep your emergency fund: under your mattress, tucked $20 bill by $20 bill into your books, or invested in your high school best friend’s cousin’s restaurant. As previously mentioned, you probably shouldn’t mix it in with your normal spending account – it’s too easy to spend it that way.

Do you really need 3 to 6 months of expenses in the account? That’s a lot of money!

If saving up 3 to 6 months’ worth of normal expenses seems intimidating, start by accumulating one month’s worth of bare minimum expenses. The next step would be three months’ worth of necessary expenses. If you are in a true financial emergency, you can probably forgo the Chipotle burritos and movies for awhile, right? Start by determining how much money you need every month. Some normal “need” categories are:

  • Rent or Mortgage
  • Utilities
  • Insurance premiums
  • Groceries
  • Transportation
  • Debt payments

Make sure you have enough money to cover these necessary categories. Rent, utilities, and groceries for obvious reasons. Insurance because you do not want to lapse on your insurance and then have something catastrophic happen. Transportation to make sure you can get to work and earn a paycheck. The debt payments – well – okay, those are slightly less necessary. But still important because you don’t want to get behind on debt repayment if you can possibly avoid it. If you can, save enough to cover those too.

Anything else can wait until the emergency is over. Yes, that includes savings and investments. I know, what kind of personal finance blogger says not to count savings in your required monthly expenses? The one that is talking about emergency funds, that’s who.

(don’t worry, I’ll hassle you to consider it a necessary expense at a later time. Just…not when it’s an emergency situation)

Take it one step at a time

Once you have three months of absolutely necessary expenses saved, you can start working towards a larger emergency fund that will cover all expenses. I just don’t want to scare you by saying “You should save $30,000 immediately!” It will take a long time to get to, say, six months of total expenses. Approaching your emergency fund in increments makes it more palatable. Your plan might look like this:

  1. Start an emergency fund
  2. Set aside $500 for emergencies
  3. Accumulate one months’ worth of bare minimum expenses
  4. Keep saving to reach three months’ of bare minimum expenses
  5. Grow the emergency fund to 3 to 6 months of total monthly expenses

Steps 1 and 2 might only take a few months. Step three might take most of or even more than a year to achieve. Steps 4 and 5, likewise, could take a long time. Take it one step at a time and remember that any emergency fund is better than no emergency fund.

Is there any other way to calculate how much money you should have?

I’m so glad you asked! I actually prefer to think through scenarios and base my emergency fund amount off that instead of going by monthly expenses. Why? Because two people, one of whom is very frugal and one who spends everything he possibly can, might have wildly different monthly expenses – but a new refrigerator is going to cost basically the same for both of them.

I’ve based my emergency fund on the amount I would need if three things happened at once: 1) finance screwed up my paycheck for a month and I’m not paid, 2) I need an emergency car, and 3) I have to fly somewhere for an emergency such as illness or death. Most likely I could pay all of my normal monthly expenses, plus buy an old-ish but safe used car, plus get a last minute full fare ticket for $10,000 or less. I like to build in a buffer, so I actually have a little over $11,000 in my emergency fund.

I am in an extremely stable career and while my pay might get screwed up from time to time, I’m unlikely to be out of a job without notice. If you are in a job where being rapidly unemployed is realistic, using the monthly expenses formula for determining how much to save might be better.

Are there any options instead of an Emergency Fund?

Depending on how you feel about credit cards, and how wisely you use them, you could potentially use a credit card as your “emergency fund.” I would only suggest this to people who have very firm control of their finances and access to assets that can be easily converted to cash. Why? Because the whole point of an emergency fund is to cover costly emergencies without going into debt. If you don’t pay off the credit card immediately, you may be putting yourself into an even worse situation.

A taxable investment account is an example of an asset that can be quickly converted to cash. The benefit of doing this is that your money isn’t languishing in a savings account earning a pittance in interest. The danger is that you might have to sell your investments at a bad time, potentially at a loss. You might also end up with a tax liability. Again, this isn’t something I would recommend for many people, but the option does exist.

Doing something like this is not the normal method. Proceed with caution, and at your own risk. Even then, maybe have a few hundred or a thousand bucks set aside in an easily accessible account “just in case.”

What you definitely should not do is rely on selling something illiquid during an emergency. Stocks can always be sold, even if it’s at a loss. A car, boat, jewelry, or Beanie Babies – those are not the kind of thing you can count on finding a buyer for on short notice. Don’t expect to sell a stamp collection to raise cash if your house floods.

 

Do you have an emergency fund? Have you ever had to use it?

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Comments

  1. Creditmarvel.com says

    May 15, 2017 at 3:48 pm

    Having an emergency fund is a must. We had a nice one up until we purchased our home..yes it was time. Trying to build it back up but it’s not easy. Beautifying and repairing eats up the money quick! But we won’t give up!

    Reply
    • MilitaryDollar says

      May 16, 2017 at 1:54 am

      You did it once, you can do it again! Good luck!

      Reply

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