How and why to start an emergency fund

Financial emergencies can come in the form of a job loss, significant medical expenses, home or auto repairs or something you’ve never dreamed of. The last thing you want to do is be forced to rely on credit cards or a loan which could simply compound the problem.

I think at least 3 months should be the minimum, and up to a year max, depending on your situation.

I don’t think liquidating investments or using a line of credit is wise because you’ll be compromising future returns or paying payments with interest on that emergency for months or years to come.

I recently wrote a post on the subject that may be of interest that is part of my “How Do You Get Out of Debt?” series. You can find it here: https://plus.google.com/103988393972958409636/posts/WkrdYfTvE8M

I would like to know just “who” are these “experts” to determine “how much is enough” to pull one through an emergency. My husband and I had 6 months of savings for just such an emergency such as job loss, a medical issue, accident, etc. When he lost his job in 2008 we weren’t too concerned because we had done everything right. We didn’t live rich because we’re not, but we weren’t poor either. We had our savings for 6 months of expenses and mortgage as “experts” indicated we would need to pull us through, but after that 6 months was gone….so was our emergency fund and any hope for him to find another job locally. So, we did everything right…..but experts are not really experts unless they themselves are in the situation currently. Today’s emergencies are different than I remember seeing them to be in my younger years. Today, U.S. families are less likely to take one another in and care for each other. Or the typical responsible U.S. family doesn’t want to feel like a “burden” on other family members. Our government (national and local) has so many hoops for a homeless person to jump through to make themselves feel safe, being fed at all much less healthy foods, or feel that they can make much progress in becoming self-sufficient without the penalties imposed or fear of penalties being imposed, and the stigma that goes with being homeless, it’s no wonder that these people choose to live in a tent down near the river close to resources that they can take advantage of in the city. The face of today’s homeless has indeed changed and become much, much younger than the “hobos’ I met riding the rail cars when I was young….and that was just as recent as the mid-70’s, not that awful long ago. Citizens of the 21st Century in all their “progress” do not want to be bothered with the responsibility of taking care of their neighbor because it just takes too much time, money and resources to “fix” the homelessness and joblessness that has ripped our communities apart or it’s someone else’s problem. The homeless are not just the mentally ill, the substance abused persons or even the lazy person we once believed them all to be. No ~ they’re not, they are our neighbors, our family, they are you and I; just one step away from being in that tent and loosing our job because we no longer have a permanent address or loosing our permanent home because we’ve lost our jobs. If you want to consult an expert…..talk to a homeless person. They are more than happy for just one person, to take enough of an interest to ask them their thoughts on what is enough.

Thank God for my E-Fund! I have been saving diligently but am not that far along-about 2 months mortgage payments in cash. However I was burgled on the 13th-quite badly burgled-and the fund was a life saver. I had to have some work done on the house and an alarm system installed plus other odds and ends-I charged it all-and paid the charges off before they even hit my statement because the Fund covered it. I still have half the fund and will start rebuilding it right away and keep on with my original plan-9-12 months mortgage payments in cash. Being burgled was awful-it will take me a long time to recover-but w/o the fund it would have been much worse. Now, I feel pretty ok and am still debt free!

I strongly agree putting up at least $1000 that is after taking care of the basic living family needs, when that happens, its an advantage to go on. For me, its simply getting rid first on extra expenditures that does not concern growth on the level of income, and instead look for safe investment on stocks or bonds. It could be easier to increase allotment for emergency fund when you have already eliminated expenses on your list and start increasing to $1500 then later to higher amount.

I am all for saving but 25% of your income as Biker suggests above is WAY outside the norm. I don’t believe anyone can do it, except maybe for a rather short period of time after landing a new job or getting a promotion (let’s leave business owners and self-employed for another story). You see, you do not leave in a vacuum and all the prices you pay, especially on big ticket items tend to go right up to where you can JUST afford it. If everyone around you were saving 25% of their earnings, I bet you would leave in the same house yet it would cost you only 75% of what it is now. The builder would not be able to charge what they do if they did not know that people would be willing to spend everything they got and then some to get the house. So, again, since you are not leaving in a desert, your efforts to build a 25% cushion will be beaten down at every corner, most especially if you buy that big ticket item like a house or a car.

It is also hard to see how an emergency fund could be untouchable even if the family slides into something like foreclosure – not an immediate catastrophic event like a car crash but similarly unpleasant nevertheless.

It would seem like if you did not try to save this much, your real quality of life will increase in very real and not hypothetical (in case of emergency) terms.

It’s all about risk.
It’s my own approach, but maybe some will find it insightful:

Imagine the worst-case scenario: you’ve injured yourself while crashing your car into your house, and the house burned down to the ground. You survive and slowly recover in about 1 year.

First, you need insurance: life, health, car, homeowners’ (if possible, short- and long-term disability too)
Add up deductibles on all your insurances. That’s the amount you need for your emergency fund.

Second, you need safety-cushion fund. One year of your basic expenses (12 x monthly basic expenses). You know how to calculate this one, right?

Third, protect your funds against inflation risk. Because you add interest from CD or saving account to your income, it’s taxed at your maximal tax rate (25% if you make $50K a year). So, build your funds in a Roth IRA. You can withdraw your contributions from Roth IRA at any time without any penalties and taxes. You’ll even have 60 days to put it back. You only can’t withdraw gains until you’re 59 years old.

If you save at 25% rate a year (after tax), you’ll build your safety cushion in 3 years (because that means you spend 75% after-tax, and 75/25=3). It will take you at least 4 years to build both funds.

Once you built your funds, you’ll be financially protected against all kind of risks.

Another way to build the safety-cushion and emergency funds is to start contributing to your 401k. Put everything into safest investment vehicle – money market fund, and let it grow untaxed. While emergency time comes, in effect you will probably be out of work, out of income, and most probably you’ll fall into lower tax bracket in that year. You would withdraw some funds from your 401k and pay 10% penalty and taxes. But because you fall into lower tax bracket you’ll save on taxes more than that 10% penalty. And that even not taking into account any employers match. If you try to calculate it yourself, then also remember about unpaid taxes while you were contributing to 401k.
In general this situation applies to singles making $40K-$100K or more and falling into high 20-30% tax bracket.

This may also be a way of life for young singles. Work for 2-3 years contributing as much as possible to 401k. This would require making at least $50K per year. Then take a year long vacation, and live frugally from that savings without work. For example, kitesurfing in Belize or Mexico for a whole year. 🙂
This is an extreme example of hacking 401k but such person would end up much better than a person saving after-tax money in saving account for such vacation.

Anyway, only once you get your funds built you may start saving to buy a house, or start investing in stocks and index funds.

Happy saving! 🙂

I just wrote a complete FAQ on the subject of emergency funds. You can find it here: http://www.btgnow.net/2008/09/btg-explains-what-is-an-emergency-fund/

It has all the information about what an emergency fund is, how to start one, conventional thinking about how much should be in there and much more.

I like that you included different PF author’s views on the subject of emergency funds though. I am intrigued by Chilton’s idea of taking out a line of credit, but I’m gonna stick with Bach on this one: a loan is a loan, you’d have to pay it back someday, whereas a larger emergency fund is your money, free and clear.

Great post!

For my situation, I think 3 months of take home pay should be enough. If things go way bad, I can cut expenses to make it last.

I am surprised nobody has mentioned iBonds. That is where I have my rainy day fund. They are guaranteed to beat inflation and have the backing of the US Federal Government. On the downside, once you buy a iBond, you have to wait one year before you can withdraw. After that, you can withdraw at any time.

This is a general comment: I love your blog and I very much enjoy the slow and steady approach to money.

As for my story: I was looking over my finances and was a bit dismayed that my net worth hadn’t budged since last year. But later, I realized that:

1) I was laid off and not working for 5 months
2) I’d taken three long and fun vacations in my time off and connected with friends and family
and 3) I bought a car (taking on debt)

Overall, I should be proud because I had fun with my time off, my net worth is a lot higher than average, and being laid off was an “emergency” and hopefully a rare situation. In general, I usually save more, but having one “off” year is OK given what I chose to do in that time.

I build up an emergency fund as a net of saviour. It will rescue me from harm of the debt.

Agree with this article……

me and my wife keep emergency fund in one envelope and it contain 3 time of my salary. and every month we add it 5% of my salary to it.

it very useful indeed…

A nice place the wife and I put our EF is in this money market fund:

https://www.americanfunds.com/funds/details.htm?fundGroupNumber=9&fundClassNumber=0

We’ve been averaging a 4.7% return and have easy access if needed.

beanspants1 –

I’m not exactly sure where you are going with that. Are you saying if I’m OK with risk I should continue carrying lower interest loans and put my money into my investments? Or are you saying there is hardly ever a scenario where investments outweigh paying off a loan?

I also wonder how compounding interest plays into this. For instance, if I missed putting $10,000 into an IRA between the ages of 22 and 24 because I was paying down debt, did I have a monster affect on my gains since I did not get to take advantage of those two or three years of compounding interest? Did I end up losing tens or hundreds of thousands of dollars in my IRA because I had to wait until 24 to begin investing? Or is that easily made up for by reduced debt and ability to contribute a lot more between the ages of 24 and 26 than I otherwise would have been able to contribute?

So if I’m O.K. with my current ratio of debt to gross income, should I continue on investing and carrying debt while making the minimum payments against my debt? Or is it simply a risk assessment…would I rather get a guaranteed 6% interest on debt prepayment or a non-guaranteed 7+% interest on an investment? (Since I’m young and have a high risk tolerance, I suspect the answer to this, for me, would be a reflection of my choice in investments. I’ve always made fairly high-risk, high-reward choices in my investments.)

I understand that this calculus is probably out the window in the situation where one is uncomfortable with one’s ratio of debt to gross income. At that point, paying off debt seems to be the most clear choice. And almost by definition, that debt is probably drawing a higher interest rate than typical.

We actually have two types of e-funds: one for short-term stuff like car repairs, and another for true “rainy day” things like job loss. The first one is in a credit union savings account, and the second one, with about a year of expenses in it, is in I-bonds.

hello,

sorry for lame question (but you are never too lame to start saving, right? and only those who don’t ask questions, don’t get answers?), what is ING account?

can people from other countries (than USA) save money in ING account? thanks for your time.

is there anything like ING in Europe?

Dear blog owner: I agree with those who say 3 months household income at a minumum.
http://millionairenowbook.blogspot.com/2006/06/seven-steps-i-used-to-build-my-simple.html
It’s step 2 of 7 for me. But, I am probably alone in discouraging IRAs and 401Ks. ooops

From a related page (http://www.fool.com/money/allaboutiras/allaboutiras09.htm , question 6) at the Fool: “Under the IRS ordering rules, you are allowed to remove your original contributions at any time without tax or penalty.”

James’s other arguments are still valid, and withdrawal becomes a problem for any conversions and earnings.

I tedn to be more of a leverage myself for financial growth girl. However, as a single mom with two kids, I see the value in having money set aside in case of emergency. That being said, I find more security in growing my money through investing, than I do having it just sitting there. So my emergency fund is just enough, while the rest of my money is being put tto work earning me more money.

Good advice! My wife and I call it “the buffer.” Basically we said our checking should have a base of $1500 and our savings should have a base of $1500. It’s not always there, but we sure feel safer when it is. I recently had to move across state for a new job, but couldn’t move my family until we could sell our place in this soft market. Living in two towns was a little expensive, but that buffer served it’s purpose. We’re all back together now, and working on rebuilding our buffer.