I used to think that emergency funds really weren't necessary, that they were just something that people who were overly cautious about money worried about. Why would i ever need to have one? After all, that's what credit cards are for! If we ever have an emergency we'll just put any expenses on the credit card, and pay it off as we go. That's what normal people do, right?
When we were taking the class “Financial Peace University” through our church, we realized just how wrong we had been. We realized that there are a lot of good reasons why you should save up an emergency fund, and the question about emergency funds is not if you'll need one, but when you'll need one. Emergencies always come knocking, you just don't know when (see one of our emergencies in the picture above). Better to be safe than sorry!
Good reasons to start saving an emergency fund
- Life Happens: I've realized more and more over time that emergency funds are necessary because life happens and small unexpected expenses WILL come up. They always seem to come up at the worst of times too. You're on a trip and your tire blows. It's the middle of winter and your heat goes out. When you have the money saved these things are an annoyance, but not the end of the world. When you're having to scrounge up money or put it on a credit card, it's much more stressful because you hadn't planned on the expense.
- Less Stress: When you have an emergency fund saved, it has an added built in bonus. Peace of mind! When you've got your baby emergency fund ($1000) you'll feel a bit of a weight lifted off your shoulders because you no longer have to worry about most small emergencies. $1000 will cover most of them. When you get your 6 months (or more) of expenses saved, you'll have even more peace of mind because you'll be able to weather just about any storm that might come your way. Job loss? You're covered. Car needs a new engine? You're covered. Unexpectedly need a new water heater? Don't worry, you can pay cash. At my house this peace of mind is especially reassuring for my wife, which means everyone is happier!
- Less Risk: When you have an emergency fund (along with other things like health insurance, disability insurance and life insurance), you have a lot less risk of bad things happening. You're much less likely to go into bankruptcy, foreclosure or to start accumulating large amounts of debt. In other words you're making sound decisions to plan for problems, before they happen.
How much money should I have in my emergency fund?
The topic of how much money should be saved is an interesting one, and to be completely honest may be a different number for different people. I tend to be a Dave Ramsey fan, so I lean towards saving at least 3-6 months of set expenses in my emergency fund. In other words, enough money to pay for my mortgage, food, transportation, clothing, etc for at least 3-6 months if no other income was hitting my bank account.
Is 3-6 months a hard and fast number? No, I don't think so. You have to figure out how much risk you're willing to tolerate, and what your personal situation is. If you're in a situation where you think a layoff is imminent, and it may be longer than 6 months before you find another job, you may want to get an extra job and save more like 8-12 months of expenses. If your job situation is more stable 6 months might be just fine. Again, figure out your family's risk tolerance, look at individual and family job situations, and decide on a number based on your situation.
Steps to funding your emergency fund
Setting up an emergency fund is one of the very first things you should do when you're trying to get your financial house in order. In fact, I think it's the first thing you should do.
- Save up a $1000 emergency fund: A starter emergency fund is a great idea to have, even if you're not out of debt yet. $1000 will be able to cover most small debts that come up – everything from a small car repair to paying for emergency travel expenses. Only the bigger things like a layoff, major car repairs, etc won't be covered by this.
- Pay off any debts: Work hard towards paying off any debts that you may have. Debt is like an anchor tied to your ankle when you're trying to swim through financial waters. Take off that anchor as fast as you can or you'll drown! Get a second job if you can, work hard, and shed that debt. Remember, the borrower is slave to the lender!
- Figure out your tolerance for risk, and decide on a number of months to save for: Look at your family's individual situation, taking into account job situations, risk tolerance, and other factors like if you have disability insurance. Once you've factored all those things in, decide on how much you want to save.
- Save up at least 3-6 months of expenses: Start saving your big emergency fund, with at least 3-6 months of expenses, preferrably somewhere between 6-12 months. Make sure you're keeping the funds in an account that is very liquid. In other words, make sure the money is easy to get to. Take small savings you're making by budgeting and snowflake it into your account, or get an extra job short term to build it up faster – especially if your job is at risk.
- Prosper!: Once your emergency fund is saved in a nice high yield savings account or money market account, sit back and relax. You've now prepared yourself for the worst case, removed risk, and given yourself peace of mind. Now you can get about the business of building wealth!
Remember, an emergency fund is only the beginning of a sound financial plan, don't forget to also start doing a budget, planning for insurance needs (to remove further risk), investing for your future, and giving to others in need!
Do you think emergency funds are a good idea, and have you started saving for yours? Tell us about your situation in the comments!