How and why you should start an emergency fund

Most personal finance experts agree: The first thing you should do — after meeting basic needs — is to establish an emergency fund.

Life is full of unexpected surprises, many of which cost money — a thief smashes the windshield of your car, your son gets sick, your water heater overflows. When people live paycheck to paycheck without any savings, they’re at the mercy of these small crises. Sometimes a tiny problem becomes a huge one because the victim wasn't prepared for possible trouble.

Fender Bender

That’s where the emergency fund comes in.

What Is an Emergency Fund?
An emergency fund — or “rainy-day account” or “safe and sound money” or whatever you’d like to call it — is a chunk of change set aside specifically for the unexpected things life throws your way. It’s not to be used to buy a new car. It’s not to be used for a vacation to Paris. It’s not to be used to remodel your bathroom. It’s for use only in case of emergency: a tree falls on your house, your youngest daughter breaks her arm, you lose your job.

I have a couple of friends who believe emergency funds are unnecessary. They're wrong. Maybe emergency funds are unnecessary if you're rich. But these friends aren't rich. For most people, emergency funds are a form of self-insurance. They're a proactive way of protecting you and your family from random crappy events.

How Much to Save in an Emergency Fund

An infographic on three steps to starting an emergency fundThough personal finance experts agree emergency funds are necessary, there’s no consensus on how much is enough. Here are just a few recommendations:

  • In The Wealthy Barber, David Chilton argues that it's best to have adequate insurance to cover the big emergencies, and to set aside between $2000 and $3000 to cover small crises and the things that insurance won't cover.
  • In The Six-Day Financial Makeover, Robert Pagliarini writes: “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.”
  • In You Don't Have to Be Rich, Jean Chatzky recommends three to six months of living expenses.
  • In Your Money or Your Life, Joe Dominguez and Vicki Robin recommend six months of living expenses — but only once you've achieved financial independence. Before that, they want you to put your money toward debt reduction and wealth building.
  • In The Total Money Makeover, Dave Ramsey recommends a two-stage approach. First, before anything else, set aside $1000 to cover emergencies. Then, after you get out of debt, boost you emergency fund to cover 3-6 months of living expenses.

My own advice is to do what works for you.

Start small. If you don’t currently have a rainy-day fund, then anything is better than nothing. Set aside $500. Or $100. Or $20. Over time, work to build this buffer until you have $1000 or $5000 on hand for catastrophe. Ultimately, you’ll sleep more soundly if you do have six to twelve months of living expenses in the bank. It’s a comfort to know that if you lose your job, you won’t lose your home right away.

How to Start an Emergency Fund

Starting an emergency fund is totally non-difficult. Anyone can do it. Here's how:

  • Pick a bank. I’m a fan of local credit unions and community banks, but I also like high-yield savings accounts at online banks. (My emergency fund is at Capital One 360, although there are plenty of other options.)
  • Build a buffer. If you’re still in debt, it’s probably best not to stick a lot in savings. You should set aside $500 or $1000 to deal with annoying emergencies like a car that breaks down, but the rest of your money should be thrown at your debt.
  • Resist temptation. When you have a big chunk of change sitting in the bank unused, it can be tempting to use it for other things. Resist the urge. Use your emergency fund only for emergencies, otherwise you defeat the purpose.
  • Save more. As your debt dwindles, and as you get better control of your finances, build your emergency fund. Pick a number that helps you sleep at night. For me, that number was $10,000. That seemed like a lot of money to me (and still does!), and if anything disastrous happened, it would help me survive for a long time.

Finally, it’s wise to keep your emergency money someplace that’s not too easy to access. (Ignore this piece of advice if you know you’re 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 internet bank. Or put the money into a certificate of deposit. Don’t carry a debit card tied to your emergency fund. You’ll still have access to the cash when you need it, but you’ll be forced to consider your actions before making a withdrawal.

When Is It Okay to Use Your Emergency Fund?

But what is an emergency? This is an interesting question, and one I've thought about a lot lately. How do you decide what is and what is not an emergency?

Sometimes the answers are easy, of course. A vacation to Florida is not an emergency and should not be funded from your emergency fund. New boots are not an emergency, and neither is a new videogame console. On the other hand, if your only car is totaled, buying new transportation is an emergency. Or if your son breaks his leg, his medical expenses are an emergency.

But what about all the stuff in between? What if your computer dies? Is that an emergency? Or should you just go to the internet cafe? What if the garage roof starts to leak? What if you have an unexpected dental bill?

Ultimately, I think the key is to decide for yourself what you emergency fund can be used for and what it can't. But once you make that decision, stick to it.

Final Thoughts

From experience, I know that it can sometimes be painful to see a large pool of money sitting unused for months (or years) on end. But also from experience, I know that when a natural disaster strikes (or any other kind of disaster, for that matter), an emergency fund goes a long way to preventing financial disaster as well.

Studies show that those without emergency savings are more likely to accumulate debt. Your emergency fund acts as self-insurance, cushioning you from small disasters. If you have a cash cushion, your financial plans can’t be derailed by a single unexpected event — unless it’s huge.

How much do you keep in your emergency fund? How did you choose this amount?

[photo by Incase]

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limeade
limeade

The goal for my emergency fund is one year’s worth of expenses. You can’t underestimate the importance of cash. Not only are you secure financially, but the peace of mind and the confidence you gain are invaluable. I’m not a fan of tapping home equity as an emergency fund. It also just doesn’t make sense. Put your emergency fund in a money market at anywhere around 4-5%. This is about what you’d save by paying your mortgage down since the interest there is tax deductible. Also, your home is not a savings or investment vehicle. It’s part of your living… Read more »

George
George

I think that the amount of an ’emergency fund’ is highly dependent on your risk tolerance and job stability. If you’re in a stable job with excellent disability benefits, the chances of your income suddenly vanishing are extremely small. In this circumstance, using a line of credit as an emergency fund can be a good idea, since you’re confident you’ll have the income to pay down what’s borrowed. If your job is less stable, or is more dangerous, you may want to have more cash on hand, in case you suddenly lose your income due to an injury or illness.… Read more »

Josh Smith
Josh Smith

We are shooting for $1000, then we will lower the monthly contribution and apply more to outstanding student loan debt.

Duane Gran
Duane Gran

It all depends what constitutes an emergency. After a natural disaster lenders may freeze or revoke a HELOC if they have reason to believe the asset backing the mortgage is devalued from the event.

yob
yob

My e-fund is for 1500 a month (covers cobra plus normal expenses) for 12 months and thus is 18,000 dollars cash (errr, well in a money market fund).

Probably too large but it is what I keep. Mind you I have agressive investments also so this helps balance out some risk my portfolio.

Jeremy Bettis
Jeremy Bettis

What kind of banker would give a home equity loan to someone who had no job? I don’t think I would want that risk.

Erik
Erik

All this “how big an emergency fund”, “pay off your debt” stuff gives me a headache. I can’t figure it out. I’m not an accountant or investment guy. I’m a programmer. Soooooo I program and when it comes to finance I play stupid. To cover myself, and my stupididty, I don’t have any credit card debt. I have two car payments and a mortgage payment. I put 10% of my salary in a 401k. And I have an emergency fund with close to $50k. I feel these moves keep me covered until I can learn more about investing and all… Read more »

Dylan
Dylan

There is no one size fits all answer to this, and this is why there is such a wide range of recommended amounts. Most financial planners are taught that 3 months of reserves (6 months for a one-income household) is as a rule of thumb. The purpose should be to have cash available to cover short term costs, like waiting for the insurance company or while you look for a new job. If you are under insured (or self insure) you may want more. Home equity serves as a nice backup to a cash reserve should you deplete the whole… Read more »

Anne-Marie
Anne-Marie

I have pondered over this question for a very long time. I am single and rent an apartment. Although I have a lot of money invested in my 403B, I do not have much saved for an emergency. When I do have a few thousand saved, something comes up such as car repair, or my computer crashes and I need to use that money that was intended to be used in case I lose my job. This shows me that I need to save more than just a few thousand dollars. I think we all need to think of the… Read more »

Covert7
Covert7

My wife and I just sat down this past weekend to go over this question. With our first kid on the way now and us dependant upon my salary alone, we decided that having 5 months living expenses would be a nice cushion in case things go bad. We keep that money in an money market savings account so we can quickly access it if need be. We also have no other debts except for the house note. I agree with what most people are saying in that there is no single hard and fast rule here and it’s up… Read more »

Anne
Anne

Personally, I don’t think I need a lot in an emergency fund, for a few reasons: I’m in a profession that lends itself easily to self-employment or work as a contractor, so if I lose my salaried position I could still find enough work to pay the bills fairly easily. Also, my necessary bills are relatively low–my mortgage payment is less than 10% of my gross monthly income, and I don’t have a car. My other big bill is my student loan payment, and I could get a forbearance if I absolutely had to. There are always other ways to… Read more »

Jon Gabriel
Jon Gabriel

You friend’s advice about the HELOC makes perfect sense analytically. However, money isn’t just an issue of mathematics. Money is emotional. Having a few months expenses sitting in a local bank conributes heavily to one’s peace of mind. Having to borrow funds when your car breaks down or you roof gets a leak only adds stress to the already stressful situation. In addition, since it is so easy to borrow money from a credit card or HELOC, one’s definition of “emergency” tends to grow rather fluid over time. If you ever want to reach your financial goals, you have to… Read more »

Greg C.
Greg C.

I don’t know. I have always wondered what is considered an “emergency”? Is it limited to things like losing a job and needing to pay for regular expenses? Car breaking down- is that an emergency ( I just pay stuff like that out of regular expenses)? Someone broke my car window a couple days ago and stole my CD player and some other things- is that an emergency? Again, something I will probably just pay out of regular funds that I don’t consider an emergency fund. Maybe since I live below my means I have a perpetual emergency fund that… Read more »

KMC
KMC

Andrea’s classmate’s advice leads me back to a thought I’ve had for a little while now (and it’s not an original thought). The people with the greatest ability to fund a large emergency fund are the people least likely to need it. For example, someone who is financially responsible and pays off their credit card each month typically has a large available card balance. If disaster hit, even if this person has no emergency fund, they have the card to function as one (albeit an expensive one). Someone who does not pay off their card each month typically won’t have… Read more »

Samuel Peery
Samuel Peery

I strongly recommend NOT using your home equity line for an emergency fund. Going into more debt is not a great way to deal with an emergency. Relying on a HELOC for emergencies fosters an attitude of lax financial planning rather than a proactive, controlled approach. It’s vital to start with at least a small emergency fund ($1,000 is a good recommendation) to get you through the minor emergencies. As you pay off your consumer debt, you can then use the funds that were going towards debt to build a more substantial emergency fund. 3 to 6 months feels about… Read more »

Tinyhands
Tinyhands

I agree that on paper the HELOC idea has merit, but from a practical standpoint I don’t think it should be the primary emergency fund. I think it would make a better emergency emergency fund.

That said, most of my emergency fund is invested. I have some cash, but the likelihood of having an immediate need for 6-12 months worth of cash is pretty slim. I can divest my holdings as necessary and have cash within 3 days, which should be good enough.

Kevin Gunn
Kevin Gunn

I’m going to agree with several others here that emergency reserves are often overdone. Now, I’m really talking EMERGENCY reserves — a dead car and the need for a new one is not in the same category of a lost job or disability. If you consider a need to make a sudden purchase such a car, refrigerator or replacement TV an emergency then you need more short term reserves. Otherwise, you should simply keep a portion of your savings in non-retirement investments (so that you don’t get a heavy tax penalty for withdrawals on them). Yes, they’ll grow more slowly… Read more »

sbf2i34gqt
sbf2i34gqt

Taking out a home equity loan when you become unemployed is not a good idea. You risk becoming both unemployed and homeless. Whether you call it an “emergency fund” or just “liquid investments” doesn’t matter, and there is no maximum amount.

Also emergencies are not just unemployment. They include medical emergiencies, natural disasters, etc.

Anne-Marie
Anne-Marie

I dont believe racking up your credit cards is a good idea either as some of the previous enteries have stated.

Dave
Dave

Home equity credit is DEBT, not “pulling money out”. You “pull money out” of a home ONLY when you sell it. Home equity lines of credit are a form of BORROWING money that MUST BE PAID BACK WITH INTEREST. As long as that is clear, you can make an informed decision about emergency funds. I bet the MBA who wrote that home equity credit is “pulling money out” probably lives hand-to-mouth on a six figure salary… little net worth. Most of the MBAs I know are miserable managers of their own money. First, define “emergency”. Is it a car breaking… Read more »

DC Economist
DC Economist

I have 6 months net income in an emergency fund, but its in staggered high-yield CD’s (about 5%APY, 8-12 month terms). I earn interest, and money is always available if I need it.

I think HELOC is a bad idea, i dont like paying interest…good budgeting should mean you dont have to deal with it

Thor
Thor

It is very much a personal decision in regards to risk and circumstances. I think having enough so that you can sleep at night and not have to sell investments or sell a home is realistic. Also, personally I keep less due to the fact that both my wife and I work, whereas if we were dependent on one job I would want a larger emergency fund. We are generally aggressive investors and likewise aggressive with our money and do not have too large of an emergency fund (~10k) but then again we have no credit card debt or mortgage… Read more »

Mark
Mark

What about sick days and vacation days. Does anyone consider that part of your emergency fund?

If you always have two extra weeks of leave isn’t that at least half a months worth of emergency money.

Then if you get paid two weeks behind your actual work days thats another half month of emergency cashflow. Your up to a whole month.

CDC
CDC

This is one I struggle with, not so much from an “emergency” standpoint, but a “just living” standpoint. I’m not currently working and don’t expect to work again for quite some time. The challenge is trying to figure out how much I should simply have in cash vs. invested. 6 months of expenses? A year? I know that I’ll have to liquidate some of my investments as I go along no matter what, but how much to keep in cash for the time being is the challenge.

finance girl
finance girl

Tapping a HELOC during an emergency? Isn’t that akin to putting gasoline on a fire?

If it’s an emergency, then things are stressful. Piling on debt in the form of a HELOC will only make things worse.

Having a few months in a short term account is all you usually need while you figure things out.

Other money can be put into stocks,MFs, ETFs, instead of an MMF(MMFs only gain 4-5% a year) and tapped as need be after that hypothetical first 3 months.

pfodyssey
pfodyssey

The concept of having an “emergency” fund is a good one. While it is typically cast as being a liquid investment that covers X months of expenses, I think that definition is a bit narrow and that the vehicles one uses to create a cushion for such an emergency should be more flexible and (as suggested), align to each person’s individual situation. For example, when I was early in my career my main focus was on maximizing savings to cap out on my 401(k), etc. Emergency savings were not a high priority for me because: A) Expenses were relatively low… Read more »

Dustin
Dustin

I would say it depends on your risk tolerances and what you feel comfortable with.

Kate Davis
Kate Davis

I have an emergency fund, but have never thought about how much it should be. I have an UK tax free account, ISA, which I put the maximum allowed in for two years which now gives me over 3 months salary.

I stopped putting money into my ISA account once we got an offset mortgage. Most of the spare cash goes into the offset to reduce the interest on our mortgage, however we can still access the money so can take money out if we need to, so I guess it works like an emergency fund as well.

Greg
Greg

I have a multi-step emergency fund. The first step is about $1000 in an ordinary savings account. It is low interest, but I can get to it quickly. I then have about three months savings in a money market account. Better interest and it takes a couple of days transfer the funds back to my checking account. Any savings on top of that goes in longer term investments that make more than the money market account. I also make sure that my credit cards balances are low.

db
db

I think there are two levels to emergency funds — the first being if your car needs a big repair or your heater/washer blows up, or (heaven forbid) you need a lawyer for some awful reason). The other reason — what I like to call the “contingency fund” is to cover sudden income loss. Having been laid off with NO contingency fund and no severance pay, I think it’s really important to have at least a few months of LIQUID savings here — preferably more. My minimum comfort level here is 6 months. In addition I’d like another 6 months… Read more »

Drak
Drak

Great article & lots of interesting comments. My own $0.02 are that while it may not make the most cents economically (pun intended!), having a 3-6 month emergency cash reserve in savings / CDs / money-market funds buys you significant peace-of-mind. My goal is to have 6 months of cash (savings/CDs/mmf) at my current lifestyle saved up. The anecdotes I have heard are that having that cash cushion will really make you feel free — give you options to quit your job if it gets too bad, or recover from a medical expense or unemployment or serious car problem. Keep… Read more »

anonymous
anonymous

i have built ALMOST a year’s worth of emergency funds.. i have no mortgage, therefore a HELOC would be out of the question for me

you can never have TOO MUCH saved for a rainy day.. i have it setup where i can easily take cash out for a necessity

checking (for everyday stuff)
then regular savings (my checking acct’s backup plan)
then ing direct (emergency funds)
then roth ira (last option.. can take out contributions if really needed)

it’s nice to have that freedom to know that if i wanted to quit my job and relax for six months comfortably, i could

db
db

Just a note for taking out a loan on a 401(k) — I’m opposed to it, especially in an emergency. And there’s no point in planning on it as a fallback. When I was laid off they wouldn’t let me take a loan out of my 401(k) — I either had to roll it all over or I had to withdraw it all. Of course, since I had NO EMERGENCY FUND, I had to withdraw it all. By the time taxes and penalties were taken out and I was re-employed, my entire retirement savings was now also gone. THEN to… Read more »

Canadian Dream
Canadian Dream

This is a very good debate. Just a few points to add. 1) I define an emergency as something that causes significant but temporary hardship on your normal cash flow arising from medical problems or job loss. Basically I can always afford the emergency in the long run, but I just don’t have all the cash right now. 2) It is ok to use a line of credit to help the cash flow out as long as you know and can handle that risk. I hate to have $10,000 just sitting anywhere in low interest when I can pay down… Read more »

samerwriter
samerwriter

I think emergency funds for many people are way overrated. If your finances are fairly healthy (and you’ll know if they are), I think it makes sense to keep a very small emergency fund in cash, and then use credit cards for your real “emergency fund”.

By definition, a true emergency should be rare. And for those rare occasions, it makes no sense to have a big stash of cash sitting around when you have easy access to credit.

plonkee
plonkee

My emergency fund is about three months expenses and is also (like Kate Davis) in an ISA. I use my credit cards as an emergency emergency fund. I wouldn’t like to use anything like a HELOC as the risk of losing my home would cause severe insomnia.

My goal for my emergency fund is approximately 5 months expenses, which would cover living expenses and say the boiler breaking at the same time.

Cathy
Cathy

See, I don’t have a problem using a HELOC as an emergency fund. If it was a major emergency (job loss), I would be forced to leave the country because of my immigration status. Therefore, I would sell the house. I have the HELOC open now, so I would just pull the money, pay the movers, and run. Since I have over 20% equity in the house, and the HELOC represents about 5% of equity (at today’s market value) I don’t think this is a terribly risky scenario. The proceeds from the sale of the house would cover the HELOC… Read more »

db
db

@samerkand — Here’s where I stand on relying on credit for emergencies. I’ve spent the last 2 1/2 years of my life sacrificing big time to PAY OFF my credit cards, more than half of which represents charges during an emergency layoff to survive. I’ve got another $10K to go. The last thing I’ll ever want to do again is rely on credit cards in that sort of cash flow emergency. So — an 8 month layoff cost me thousands on credit cards and wiped out my entire retirement. Failure to be prepared, I counted on credit and retirement as… Read more »

HalOtis
HalOtis

To me, emergency money would be for anything that would normal require going to the insurance company.

I myself don’t like the idea of insurance, I’d much rather have an emergency fund that could handle most everything. Especially smaller items.

The more money that is in my emergency fund the less insurance I would need from insurance companies.

anonymous
anonymous

samewriter.. using credit for those rare emergencies might be a good idea for those who have thier financial situation under control

BUT we’ve already seen what credit cards do to people who can’t control their spending.. i just don’t see that as good advice

dimes
dimes

$15K. That’s six months of living expenses. No reason why we have that amount. We don’t own a home though so HELOC is obviously out of the question.

icup
icup

I tend to lean towards pumping it back into your mortgage (after ensuring a basic fund that can handle most emergencies). Keep in mind that an emergency can happen at any time, but the corollary to that is that an emergency MAY NOT (AND LIKELY WON’T) HAPPEN AT ALL. If some big emergency does come up beyond your basic fund, your money is still there in your equity, you just have to fill out paperwork to get it. And as a bonus you won’t be (as) tempted to dig into the money to go on vacation to Hawaii But what… Read more »

Bryant Keefe
Bryant Keefe

I keep six months of reserves in a money market account and find this adequate for my families security. I do like clients to have HELOC’s avaiable for opportunities like a great investment or short-term major housing expenses. Using a credit line for weathering a set back is bad advice as this would increase your monthly obligations as you increased the balance. That being said if a credit line is the best you can do because your are incapable of saving money then use it sparingly. The challenge you may have is if you cannot save moeny then having access… Read more »

Elissa
Elissa

Well, I don’t have a house… but I do have an emergency fund! I was able to get it over $1000 in about 5 months by putting 12% of my monthly net income into it. Now I plan on cutting back on that just a little bit and putting more towards paying down debt, one bill at a time. 🙂

Andrea >> Become a Consultant Blog
Andrea >> Become a Consultant Blog

Thanks, everyone. I’m not sure my point / my classmate’s point came through here. Instead of having, $30k in an emergency fund, you throw that money (in one chunk) at your mortgage. If an emergency happens (which I pretty much only count as unemployment), you pull that same $30k back out. It’s debt that would have existed if you had the emergency money liquid somewhere else. For example, you have a home worth $500k. You owe $330k on your mortgage. Instead of having $30k in an emergency fund, you put $30k against your mortgage, bringing it to $300k. You keep… Read more »

Lazy Man and Money
Lazy Man and Money

I had been claiming that it’s far better to use a Home Equity Line of Credit for almost a year now. I think Samerwriter had it right, “By definition, a true emergency should be rare. And for those rare occasions, it makes no sense to have a big stash of cash sitting around when you have easy access to credit.” Basically you are losing thousands and thousands in opportunity cost by not having this money optimally invested.

db
db

They don’t change my suggestions. I think, frankly, that it’s a stupid idea to do this with a HELOC. If you ever pull it out, you’ll be subject to interest and you’ll have to pay it back. Wouldn’t it be better to just have the cash sitting and ready for you? If you deplete it, you’ll have to build it back up again but there won’t be any interest. I’m coming from the perspective of losing a job too — if you lose a job you want to be able to be as liquid as possible. Including being able to… Read more »

Andrea >> Become a Consultant Blog
Andrea >> Become a Consultant Blog

Well, we’re a two-income family, so there’s always someone to buy groceries and clothes. Yes, there’s interest on a HELOC. But if you go, say, four years with continuous employment and then take out a HELOC and have to pay it back over four years, isn’t this the same as the four years of foregone mortgage interest? And, if you have, say $200k equity in your house and you take out a HELOC for $30k, your equity is $170k. This is the same equity as if you had never paid down the mortgage with $30k in the meantime and you… Read more »

db
db

In my way of thinking, $10K in the bank earning some amount of interest is appropriate for an emergency fund. A CD or Bond is less desireable but ok. A HELOC is not. Why? Equity should not be used as a savings account or a line of credit. Period. I simply object to it. IMHO, the reason the real estate market in the US is in trouble right now is partly because people take inappropriate liberties with their equity. I ask again, if the idea of your mortgage sitting there is so onerous, why not keep $5K or $10K in… Read more »

db
db

P.S. We have unemployment insurance in the states too, and I used it while unemployed. I got the maximum payment allowed, and it didn’t even make my rent payment. (I’d also exhausted my benefit before I got a new job.) It’s great that you are a two income family — if you’re a consultant you’re probably not that far from having the ability to get a contract. Not everybody is in that position. I wasn’t, and though I’m very employable (great resume, mid-career, pertinent masters) I was laid off because the industry I’m in (IT) was in a downturn. So… Read more »

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