“Pay off your debt.” “Max out your IRA.” “Buy a house.” “Get a new job.” Personal finance advisers bombard us with a litany of things we ought to do in order to achieve financial independence. It’s overwhelming. Where’s a person to start?
Most personal finance books agree: The first thing you should do — after meeting basic needs, and while reducing spending — is to start an emergency fund.
What is an emergency fund?
An emergency fund is an easily accessible stash of money for use only in case of emergency. It is not to be used to buy a new car. It is not to be used to buy a new PlayStation. It is not to be used to remodel your bathroom. It is for use only in case of emergency.
Why do you need an emergency fund?
It may seem like a silly question, but some really do want to understand why they need an emergency fund. Here are some real-life emergencies that have happened recently to people I know:
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- A client’s two children were in a horrible accident Monday night. One died and the other is in intensive care.
- My little brother decided to pack up and move across the state to start a new job.
- A friend’s garage door collapsed.
- My neighbor had a heart attack last week.
- Oregon’s largest private employer (Intel) just laid off over 10,000 workers.
These are all emergencies of one degree or another. In each case, those people with an emergency fund are going to be in better shape than those without one. Studies show that those without emergency savings are more likely to accumulate debt. It may feel like you can’t afford to have one, but the truth is you can’t afford not to have one. Emergency funds are essential, even for college students.
How much is enough?
Though personal finance experts agree emergency funds are necessary, there is no consensus on how much is enough. Some say you need to save a year’s salary. Others believe $1,000 is sufficient. Most advice tends to fall someplace in the middle.
How much do you really need? As usual, I recommend that you do what works for you. There is no one right answer. Examine your situation — your income and your needs — to decide how much you should save. (My wife and I have a $5,000 emergency fund, which would pay the mortgage for three months, or all expenses for two months. This seems right for us.)
How do you get started?
Starting an emergency fund can be as simple as depositing $100 into your high-yield online savings account. But before you begin, be sure that you are meeting your basic living expenses. And as you build your emergency fund, be sure you’re also reducing your spending and avoiding debt.
I think it’s wise to keep your emergency money someplace that is not too easy to access. (Ignore this piece of advice if you know you are disciplined enough not to use the money for other purposes.) You might, for example, open an account at a bank across town or deposit the money with an online bank. Don’t carry a card tied to the account. You will still have access to the cash when you need it, but you will be forced to consider your actions before making a withdrawal.
What do the experts say?
I checked the personal finance books on my shelves to find out what the experts had to say.
In The Wealthy Barber [my review], David Chilton writes: “I’m not against emergency funds, but I do feel that $2,000 to $3,000 is much more realistic than $10,000. If you’re afraid that an expensive emergency looms in your future, establish a $10,000 credit line at your bank.” Chilton believes most people have insurance to cover many emergencies, and $2,000 or $3,000 is enough to meet the needs insurance will not cover. In the meantime, if you need more, you can liquidate investments.
Robert Pagliarini, in his forthcoming The Six-Day Financial Makeover, declares that an emergency fund is the most important financial step after taking care of basic living expenses. “Your emergency reserve is your financial cushion in case something goes wrong and you lose your job or you need access to money quickly. Your emergency reserve should consist of at least three months’ worth of cash. Once you’ve saved enough for the cushion, you can [move on] to other goals.”
The Wall Street Journal‘s Complete Personal Finance Guidebook says: “How much is enough? The answer is different for different people in different situations. For those in careers with a large, ongoing demand or who have relatively strong job security, three months’ worth of expenses is probably enough of a cushion. Those with bigger career demands, such as higher-paid managers and executives or couples who work in the same industry or at the same company, might want nine months to a year’s worth of expenses in the bank. Yes, that’s a lot of money to save, but financial security is a game won by the most prepared to outlast the tough times.” Use a money market account for your emergency fund, the book recommends, but keep several hundred dollars in cash someplace safe in your home.
In You Don’t Have to Be Rich, Jean Chatzky recommends three to six months of living expenses. Your Money or Your Life recommends six months of living expenses, but only once you’ve achieved financial independence.
In The Automatic Millionaire, David Bach recommends the following three steps:
- Decide how big a cushion you need. Bach recommends three months of living expenses, though he believes more is better.
- Don’t touch it. “The reason most people don’t have any emergency money in the bank is that they have what they think is an emergency every month. A real emergency is something that threatens your survival, not just your desire to be comfortable.”
- Put it in the right place. “Not earning interest on your emergency money is almost as bad as burying it in your backyard.”
I like the approach espoused in Dave Ramsey’s The Total Money Makeover. Ramsey’s very first step is to save $1,000 in an emergency fund. Then he advocates eliminating debt via the snowball method. Only once your debt has been eliminated does he recommend building a three- to six-month cushion. This is excellent advice.