There are some things in life you can’t plan for:
- getting laid off from work
- your car breaking down
- an unplanned pregnancy
- being unable to work due to health issues
- the A/C breaking down in the middle of summer
- Fido or Fluffy getting sick (Jake, Riker, and Pip in my case)
- the list goes on
In the 40+ years most adults will work, an unexpected event is going to happen. It’s not a matter of if, it’s a matter of when.
My mom and dad used to force me to save some of my money that I earned when I was a kid. Of course, I hated it. I wanted to spend it all on candy. And toys. And more candy. They would say I needed to save it for a rainy day – whatever that meant (nothing to me as a teenager).
Wouldn’t you like to be ready for a rainy day?
Emergency funds – the strongest financial foundation
Your plan for financial freedom needs a foundation. This foundation consists of the simplest form of savings available – money you can get to quickly, without any penalties, and that won’t incur debt.
This money will serve as your emergency fund.
I’ve had an emergency fund for 15 years and I’ve had to use it twice. The air conditioning broke in our townhouse just after we were married ($3,000) and the air conditioning broke in my current home in 2014 ($1,800).
Can’t I use my credit card?
For most people, the rainy day fund is Visa and MasterCard. This is a terrible idea because you will be creating debt at the worst possible time – when you can’t afford to have more debt.
If you lose your job, you don’t want to be taking cash advances on your credit card. Now not only don’t you have an income, but also you have huge credit card bills to pay. That’s a double whammy.
In the economic downturn of 2008–2009 credit card companies were slashing the credit limits and cash withdrawal limits of their customers (yes, they can do that). Even if the customer had an excellent credit score!
If your plan is to use a credit card for emergencies and your credit limit is suddenly slashed – what will you do?
If you have home equity line of credit (HELOC) on your home and you lose a job, the bank can cancel your credit line.
There are serious risks when relying on credit to handle emergencies. You need to have cash.
When you have cash available for emergencies, you’ll sleep like a baby.
How much do I need in my emergency fund?
The general rule of thumb from financial planners is to have quick cash available equal to three to six months of expenses.
When I first learned about emergency funds I had a big mortgage and no cash savings. That’s not a good situation to be in if I had lost my job. Ooops!
Ok, so which is it?
Everyone’s situation is different.
Six months is the most conservative estimate. It’s better to have too much than too little.
If you have a disability policy, for example, most policies kick in after 90 days of being disabled and unable to work. In that case, you need to cover three months of expenses prior to collecting benefits.
If you are a two-income household with a bunch of rental properties as income, losing one of the incomes may not be that big of an issue.
If you are a commissioned based salesperson and the only source of income for a family of seven, six months may not be enough.
Why not more?
The money in your emergency fund is usually earning little to no interest. That’s ok – it needs to be accessible. You wouldn’t want to have an emergency fund to cover several years of expenses because then too much of your cash is idle and not earning interest.
Having too much idle cash isn’t a good idea either.
The big emergencies – job loss, medical issues – are typically not going to cover extended periods of time.
New jobs come along. People get well.
If you want a more precise answer see How Much Money Do You Really Need In Your Emergency Fund.
Where to stash your cash for your emergency fund
First make sure to keep your emergency funds separate from your other spending. It just makes life easier to keep track of.
Good choices to keep your emergency funds include:
- savings account
- money market account
- checking account
What happens if there is an emergency?
You pay for it with cash out of your rainy day fund. By doing so, you don’t create any more debt for your family.
If you do have an emergency and deplete your rainy day fund by any amount, your first order of business is to build it back up.
Another storm is coming.
Where do I start?
Do you know that nobody ever starts out with a fully funded emergency fund? That’s great news if your emergency fund balance is zero! You’re in good company. Here are the steps you should take to get prepared:
- Recognize the importance of having an emergency fund.
- Set a goal of building it up.
- Make regular contributions to your emergency fund each month until it contains three to six months of expenses.
Soon enough, you will have a giant umbrella that keeps you dry when the unexpected threatens to rain on your parade.
If you don’t know if it’s an emergency or not please ask me. Send a tweet to #askscott or an email to firstname.lastname@example.org
Question: How much do you have in your emergency fund? Please leave a comment below.