The emergency fund is the first line of defense against going into debt. Let's face it, life happens.
When life hits you in the bank account, will you have enough emergency fund money to not go into debt?
Well, it is time to build your emergency fund, and you need to build it as fast as you can.
Even if you are debt-free, except for some expenses like your mortgage, emergencies will happen, so you have to be ready all the time. What if your car broke down suddenly? Or the roof of your house needed replacement?
To avoid incurring new debt, it is important to build a cash cushion.
No matter what you call it, “a rainy day fund” or “a pile of extra cash,” an emergency fund can go a long way in giving you a sense of security and peace of mind.
What Is an Emergency Fund?
An emergency fund is a readily available asset to help navigate different financial problems like a debilitating illness, job loss, or major repairs to your car or house.
The primary purpose of this is to boost your financial security by developing a safety net of cash or similar liquid assets.
These assets are to be used for meeting emergency expenses and reducing the need to turn to high-interest debt options.
Unsecured loans or credit cards or damaging your financial security in the future by using your retirement fund can all be saved if you have an emergency fund.
An emergency fund must contain enough cash to cover expenses good for three to six months, according to financial planners.
Take note that there are no accounts in financial institutions that are named as emergency funds.
It means that it is the responsibility of the person to set up this kind of account and allocate it as a capital meant for personal financial hurdles.
Emergency Fund vs. Savings
An emergency fund covers those unplanned expenses or situations:
- job loss
- unexpected bills
- car problems
- appliance replacements or repairs
- unexpected life circumstances or death.
Your emergency fund is only to be used if a financial crisis occurs.
You can sleep soundly at night when you know that in case any or some of these situations do happen, there will be money to keep you covered in most cases.
Savings, on the other hand, is the amount of money you set aside for a particular goal like appliances, childcare, down payment for a home or car, education, furniture, hobbies, and investments.
These are planned and expected expenses instead of haphazard emergencies.
People usually save to meet a specific goal that they have been planning for some time.
It prevents them from spending money they don’t have through using credit cards and improves discipline after they achieve the said goal.
How Much Emergency Fund Should I Have?
Most experts advise people to save three to six months of their living expenses in their emergency fund.
However, the amount you will need may vary depending on your lifestyle, your profession, and other available resources you might have.
Sadly, many households don’t have any emergency savings.
With no financial cushion to spend for unexpected events in your life, it is likely that you will borrow money or skip paying your bills to cover unforeseen expenses.
As a result, this can compromise your financial well-being.
How will you decide on the amount of emergency fund you should have? First, you have to determine how much you are spending.
You can start by tracking all of your expenses for a few months.
Divide these expenses into two categories, namely nonessential and essential.
Items considered as essential expenses include the following:
- Mortgage payment or rent
- Recurring debt payments
The nonessential expenses often include the following:
- Dining out
- Other discretionary expenses
Add up the total expenses for essential items.
This is how much you will need for covering your monthly basic living expenses.
This doesn’t include additional expenses you can do away with if a true emergency happened.
If you will use the three- to six-month benchmark, you will need three to six times your total expenses for your emergency fund.
If you think you cannot save that much, set aside whatever you can. Small amounts, once saved consistently, can add up over time.
How Much for an Emergency Fund Taught by Dave Ramsey
According to Dave Ramsey, if your household and income are more stable, you will have a lesser need for an emergency fund.
If you have had a steady job for quite some time now or you are part of a household with two income earners, then an emergency fund good for three months might be fine.
However, if you are self-employed, have straight commission as earnings, or belong to a single-income family, then it might be wise to have a six-month emergency fund saved.
Losing your job may make it impossible for you to pay your bills.
Your goal should also be to create a six-month fund if there is a household member suffering from a chronic medical condition that will require frequent hospital or doctor visits.
Even if your monthly budget has enough room to pay for these expenses, it is better that you stay prepared in the event that a big emergency occurs.
Emergency Fund Calculation
What is the accurate way to calculate your emergency fund?
- Begin with your monthly expenses (ME).
- Determine your income margin (IM).
- Identify your income handicap (IH).
- Consider your possible emergencies (PE).
The following is the formula to calculate your emergency fund:
Emergency Fund = (ME x 6) + (IM x 3) + (ME x IH) + PE
This is roughly six months’ worth of monthly expenses plus three months’ worth of income margin for covering lean months, plus a few months’ worth of monthly expenses in relation to income handicap, plus the additional fund for possible emergencies.
Where Should I Keep My Emergency Fund?
There are several places where you could keep your emergency fund:
Bank savings account
I personally suggest CIT Bank to hold your emergency fund. They have give as high as 2.2% interest on your money in the savings account.
See the current rates and start saving here: CIT Bank Savings Account
Among the best places to keep your emergency fund is in your bank savings account.
Even though savings accounts are known to have the least interest rates, your goal is not to make money out of this particular cash stockpile.
Instead, you just need it to be there for covering emergencies that may happen so that you won’t have to use your credit card.
You will also want it to be readily available and easily accessible.
The best thing about a savings account is the fact that you can open it at the bank where you have your primary checking account.
If an emergency situation happens, you just need to write a check for paying the expenses and transfer the cash electronically from your savings to your checking account to have the check covered.
In case you want your savings to earn somewhat better interest than in a savings account, your next best choice is a money market account (MMA).
There are not a lot of risks to your money compared to the stock market, for instance.
Most MMAs can make it through recessions without losing the money you allotted to it.
Just make sure that you look for an MMA with free privileges for check writing so that you can have easier access to your funds.
Certificates of deposits
Certificates of deposits (CDs) offer a fixed return rate for a particular length of time.
Since there is a guaranteed rate, opening a CD can be a great way to earn additional interest for your emergency fund.
In a Safe Inside Your Home
It may sound old fashion or even funny, but it is not a bad idea to have a small amount of money in your house that you can use if an emergency occurs.
You might want to have $100 to $500 saved in the house for emergencies. The explanation for this is simple—ease of access.
If your garage door malfunctions or your water heater breaks down, you will have some handy cash with no need to bother going to the bank to get some money.
This available money is ideal for those small emergencies.
However, you might not necessarily need to place this under your mattress.
You can keep it in your safe, a jar in your basement, a book, or somewhere else.
Make sure it is tricky to find or difficult to see so that you won’t be tempted to spend it for non-emergencies.
The last thing you want is to pay for your pizza using your emergency cash.
Examples of an Emergency Fund
Here are some examples of an emergency fund:
- Justin and Martha are a married couple with a monthly total expense of $5,000, including food, mortgage payments, car payments, and some necessary outlays.
They need to set aside a minimum of $15,000—equivalent to three months of expenses—and up to $30,000—good for six months of expenses to cover unexpected financial hurdles.
- Samantha sets aside $25 weekly in her emergency fund. After two years, she will have saved $2,600.
She decided to increase the amount to $50 per week for her savings to grow to $5,200 in two years. She then made it $75 weekly to save as much as $7,800 in two years.
The Bottom Line with Emergency Fund
Making sure that you have enough in your emergency fund can give you much needed peace of mind. This also helps you stay away from debt while maintaining good financial health.
Most experts advise saving three to six months’ worth of your living expenses.
However, the amount that you have to save might vary according to your lifestyle, profession, and other resources that you have.
If you don’t have that much spare cash, you can begin small and be consistent with your savings.
It will add up over time and serve as a good cushion in case financial problems happen along the way.
The emergency fund is the first line of defense against going into debt. Let’s face it, life happens. When life hits you in the bank account, will you have enough emergency fund money to not go into debt?