Do I Need An Emergency Fund?
Article by R. Joseph Ritter, Jr. CFP® EA
I often hear the question, “Do I need an emergency fund?” My response is that you need an emergency fund just as much as you need to breathe oxygen to stay alive.
The next question is, “What is an emergency fund?” An emergency fund is a cushion against life. Most people have experienced unexpected car repairs, home repairs, or medical treatment. If the expenses associated with these events are significant, many households do not have enough money on hand to pay up front. The charges then end up on a credit card.
A credit card does not qualify as an emergency fund! Let’s say in March you just finished paying your $2,000 credit card balance for Christmas spending when the transmission in your car has a major malfunction and requires a total overhaul at a cost of $3,500. The charge goes on your credit card, and you plan to pay it off over 3 months. Then, in April, you have a roof leak that costs $1,500. This also goes on the credit card. In May, you wake up one morning like I did in terrible pain and wind up in the emergency room facing surgery that you didn’t see coming. Despite health insurance coverage, the deductibles and co-pays amount to about $6,000.
In the span of 3 months, you can easily wind up with $10,000 of bills to pay without enough money to cover them. Without an emergency fund, the bills get put on your credit card to be paid off over the next year. However, the credit card payments may put extra stress on your budget that you’re not sure how to handle.
Having an emergency fund on hand gives you a source of money from which to pay for unexpected events in life and not have to wonder where the money will come from or whether you can pay off a credit card balance later.
The more you have in your emergency fund the smaller your emergencies will seem and the fewer crises you will have in your household.
How much should you have in your emergency fund? This number will be different for each individual, family and household. The common rule of thumb is 3 to 6 months of expenses. The difficulty is knowing which expenses to include in calculating the amount to set aside. The best way to plan is to consider the worst case scenario, such as disability or job loss. If you were not working and needed to get by for 6 months, which expenses would need to be paid?
You can easily look down through your budget and mark the categories that would continue to be paid, categories that will be reduced, and categories that can be eliminated. This number multiplied by 3 to 6 months then becomes your target savings amount.
Do I use 3 or 6 months as a guide? And how do I allocate money to the emergency fund if there isn’t extra money in my budget? The emergency fund can be a moving target in the sense that more is required at different times of life. When you are working, raising a family, and have dependents who rely on you for support, a bigger emergency fund is recommended. If you are single and have few expenses, you can get by with a smaller emergency fund. Whether to use 3 or 6 months also depends on how quickly you can replace lost income if you go through a disability or job loss, how quickly you can replace the emergency fund, and the availability of other sources of assets.
For example, if you have advanced training or skills or are employed in a high demand field, you may be able to replace your income fairly quickly. If, on the other hand, you are self-employed and can be affected by seasonal changes in the economy, it may be awhile before you have replacement income.
How you begin saving in the emergency fund especially if your budget is already tight becomes a matter of priorities. My first recommendation is that you begin by setting aside any extra money into your emergency fund. This may be gifts from others at birthdays or Christmas, left over cash in your envelope system at the end of the month, etc. I would encourage you to set incremental savings goals, such as $500, $1,000, $2,500, $5,000 and so on. Having just $500 or $1,000 available in a savings account will give you a significant amount of relief knowing that you have a little money set aside in case something happens.
Another option is to “sweep” remaining cash in your checking account from month to month into a savings account. “Sweep” means that any money left in your checking account at the end of the money is transferred to a savings account. This is used in a cash system when you set aside the budgeted amount of cash each month for expenses, however, you can do this regardless of whether you use the cash system. Even though we do not use cash envelopes anymore, I still sweep the balance in our checking account from month to month into a savings account. This ensures we are saving something on a regular basis and protects left over money from being spent.
Re-training your mind and spending habits is an important part of building an emergency fund. When at one time you may have enjoyed spending extra money at the end of the month on a luxury item, implementing a budget, using cash envelopes, and sweeping left-over money into a savings account each month is part of an overall shift in the way you handle your money.
And, yes I do recommend putting your emergency fund in a separate savings account and not mix it with any other money. If you keep other money with your emergency fund, you risk spending from the emergency fund or losing track of how much you have available.