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HTML clipboardWhat would you do if your car's transmission went out today and it cost $3,000 to replace it? Do you have that much money available to spend on a major car repair? Or would you have to use a credit card or loan to cover the expense?
Most people have to borrow money to pay these kinds of expenses. But, that isn't the best option. Borrowing money costs money. You end up paying a higher cost for the emergency - the true cost of the expense plus interest on what you've borrowed. The, you have the extra debt that to worry about paying off. The solution to this type of dilemma is an emergency fund.
An emergency fund is savings that's set aside to cover the expense of an emergency, like a car repair or job loss. It keeps you from taking on new debt and saves money that would have been spent on interest and finance charges.
Who Needs an Emergency Fund?
You need an emergency fund to pay for financial emergencies and prevent accumulation of debt - to keep your car running if it breaks down, to stave away medical bills, to cover necessary expenses if you lose your job. You can't necessarily plan for any specific emergency, but since we know they come, we can generally plan for them all.
Everyone with living expenses needs and emergency fund, even college students and some teenagers. If you're responsible for paying for anything on your own, you need an emergency fund.
With Emergency Funds, Size Matters
You'll find varying advice about how much emergency fund you need. Financial guru Suze Orman recently stated you should have 8 months of living expenses based on the current unemployment trends. Dave Bach, author of The Automatic Millionaire recommends at least three months of living expenses. You'll generally see advice to save at least three to six months of living expenses. If your bills run $2,000 a month, then you'll need anywhere from $6,000 to $12,000 in an emergency fund.
Saving up such a large amount of money can be intimidating. Many people completely forgo an emergency fund because they can't imagine ever saving up that much money. This perpetuates the debt cycle since there's no savings to fall back on. I prefer the approach recommended by Dave Ramsey in The Total Money Makeover. He suggests stashing away $1,000 quickly, then saving three to six months of living expenses only after eliminating debt via the debt snowball.
Following Dave Ramsey's approach, it could be years before you're able to save up the ideal emergency fund, especially if you have a large amount of debt. So, you may want to increase the initial "stash away" fund to a few thousand dollars, followed with snowballing your debt, and finally building a larger emergency fund.
No matter your approach, the key is to build stash some money in your emergency fund quickly so you have something you can access when immediate emergencies arise.
Building a Solid Emergency Fund
You build an emergency fund similar to how you save up for other big financial goals, by setting aside a portion of each paycheck. Make sure you meet all your other financial obligations before you contribute to your emergency fund. Then, take what you have left over and put it in your fund. If you use a monthly budget, create a new expense called "emergency fund" and allocate some funds to it. That way, building your emergency fund becomes part of your normal monthly expenses.
You can speed up your emergency fund, by cutting your spending. Reduce your expenses and only purchase the necessities. This will give you more money to spend each month. Also, if you get a windfall, like a tax refund, put it in your emergency fund to build it up faster.
It's a good idea to put your emergency fund in an account that's a little hard to reach. An online savings account is a good option because you can't withdraw the funds on impulse. You might also consider using a bank that's 20-30 minutes away from you. Don't get an ATM card with your emergency fund. That will help keep the money in your account.
To Use or Not To Use
Once you've built an emergency fund, it's key that you use it for true emergencies only. Emergencies are things that are necessary for your survival. Here are some examples:
- Necessary medical expenses that aren't covered by insurance
- Major vehicle repairs
- A car or home insurance deductible
- Pay for regular expenses after a job loss
- Cover an unexpected tax bill
Here are some times you shouldn't use your emergency fund:
- To keep your cable from getting disconnected
- Buy a new set of furniture
- Go on vacation
- Buy a new stove (when your current stove works fine)
- Fix the dishwasher (hand washing the dishes is a viable alternative
Before you dip into your emergency fund, always think of less expensive alternatives that can be used until you can afford to cover the "emergency" out of your regular income.
Always replace any money you spend from your emergency fund. Otherwise, your fund will get depleted and won't be there when you need it.
Increase your emergency fund as your cost of living increases. For example, if you get married, have a child, or raise your insurance deductible, make sure your emergency fund increases, too.
