This is a guest post from Dylan Ross. Dylan is a long-time member of the Get Rich Slowly community: a frequent commenter and occasional guest author. He’s also a Certified Financial Planner. This article is an abridged version of a chapter Dylan contributed to Investing in an Uncertain Economy for Dummies, which was recently published by Wiley. See the end of this post for a chance to win a copy.
Even if you’ve never had to quickly come up with money for something you weren’t expecting, you always face the possibility of needing money in an emergency. Emergencies are unplanned expenses that require more money than you can cover with your paycheck, even if you cut some expenses until next payday. When you don’t have enough in savings, emergencies can put you in debt or deeper in debt. An emergency fund helps protect your finances.
Unexpected expenses may be one-time or recurring. Potential uses for emergency funds include car repairs, paying bills if you’re out of work, large medical costs, insurance deductibles, critical home repairs, legal defenses, travel to attend a funeral, natural disasters, and so on.
Figure how much to set aside
At an absolute minimum, set aside enough money in your emergency fund to pay for at least three to six months of basic living expenses (the regular and essential expenses you must pay to live). These expenses don’t include discretionary items like entertainment, dining out, or spa treatments. Keep at least six months of basic living expenses in your emergency fund if you’re single or living on one income, or if one income in your two-income household varies a lot from month to month or isn’t secure.
Your emergency fund does more than just cover expenses in case you lose your job, so resist the temptation to keep less in savings. If you anticipate more frequent or more severe emergencies than three to six months of basic living expenses can cover, increase the size of your emergency fund. For example, you may need a larger emergency fund if:
- Your job security is questionable.
- You’re about to have a baby or purchase a new home.
- You have numerous aging household appliances.
- You drive an older car.
- You live in an area prone to severe weather, earthquakes, or other disasters.
- You engage in activities that may require frequent trips to the emergency room, doctor’s office, or the first aid aisle of your pharmacy.
Your emergency fund is also handy when you need to make insurance co-payments or pay for charges not covered by a health, dental, or vision plan. Sometimes you may need cash until you’re reimbursed by an insurance company or flexible spending account. Consider any unreimbursed medical expenses from the past few years when deciding whether to increase your emergency fund.
If you’re feeling especially uncertain, add to the size of your emergency fund. You can always reduce it after you’re through a rough patch.
Handle your emergency fund with care
The tricky thing about financial emergencies is that you don’t know what they’ll be, when they’ll happen, or how much you’ll need in order to cope until you can recover. All these unknowns make your emergency fund an important part of your financial profile and one that you should treat with special attention and care.
Make your emergency fund a high priority. The harder you think it is to come up with money for an emergency fund, the more you need one. If coming up with money to start an emergency fund now will be a sacrifice, imagine how tough it will be when you have to pay the costs of an emergency situation.
If you’re trying to pay off credit cards or high-interest loans, start with an emergency fund that could cover one month of basic living expenses. After you save one month of expenses, put extra money toward your debt payments. When your debt is paid off, build your emergency fund as quickly as possible. Otherwise, a sudden emergency could send you right back into the red.
Keep your emergency fund in cash types of investments. This money should be quickly available with no risk of decreasing in value at any time. An emergency fund is self-insurance, not an investment. You want your money to be accessible, but you also want to earn some interest on it so that you offset inflation at least partially, if not completely.
Some places to keep your emergency fund savings include:
- High-yielding direct savings accounts. Online savings accounts often pay a higher than average interest rate. You can, and should, establish an electronic transfer link to your checking account.
- Savings and money market accounts. These are interest-bearing accounts at banks or credit unions. Being able to electronically transfer money to your checking account is best.
- Money market funds. Not to be confused with money market accounts, these are funds offered by mutual fund companies and brokerage firms. You redeem fund shares to get cash out. Some accounts allow you to write checks to access the cash.
- Interest-bearing checking accounts. These accounts pay less interest than savings accounts.
- Certificates of deposit (CDs). These banking deposits guarantee a specific interest rate if you hold them for a specified period of time. They aren’t an ideal place to keep your emergency fund money because you usually have to pay a penalty to get your money out early.
When deciding where to keep your emergency funds, make sure you know how and when you can access your cash. Can you get to your money after business hours? What about on weekends and holidays? Can you use checks, an ATM, or a debit or check card? Also, make sure you’re comfortable with whether or not the account is insured.
Don’t use available credit as an emergency fund! Credit cards and home equity lines of credit could serve as a backup to your emergency funds in the event of a catastrophe, but the whole idea of an emergency fund is to keep you form adding debt. Some emergencies could affect your ability to make minimum debt payments, and missed payments, late penalties, and finance charges can easily snowball out of control.
Use your fund wisely when the time comes
Sooner or later you’ll have a large, unexpected expense you can’t cover with your paycheck. First, decide whether it’s a real emergency. Do you need to spend the money right now? Can you make do until you can save up to meet the expense? Your answer may be influenced by other events. For example, if your dishwasher bites the dust, you may decide to save up for a new one while you hand-wash dishes because of layoff rumors at work.
When you face a real emergency, access only the minimum amount of money necessary to get you through the emergency. Cut any unnecessary expenses and direct any available income toward your emergency before accessing the emergency fund. When the emergency is over, rebuild your emergency fund as quickly as possible, before reinstating nonessential expenses.
Two book giveaways in one week! Strange, but true. This time I’m giving away two copies of Investing in an Uncertain Economy for Dummies. To qualify, you must leave a substantive comment discussing your approach to emergency funds. I’ll randomly select
two five winners on Friday. Motorcrash image by Incase Designs.