Always expect the unexpected. If you believe this motto and you should then you probably already have an emergency fund. The primary purpose of an emergency fund is to provide a financial cushion to cover unexpected expenses. You need this to cover car repairs, medical bills, a new washing machine when yours dies, and most importantly, daily expenses in the event you lose your job. Overuse of credit cards can ruin your financial life, and you really don’t want to resort to them to cover your expenses during an emergency.
While some experts say that 3 months expenses is a sufficient cushion, others recommend 6 and still others suggest a full year of expenses socked away. The size of your emergency fund should depend on several factors (but in no event should it dip below 3 months):
How secure is your job?
The less secure your employment, the more you should have saved for a rainy day.
Do you have a family to support, or are you still living the single life?
Obviously if you are a single income family supporting a large family, you better have a large emergency fund to support your family in case you lose your job. Id suggest a full year of expenses. If you have a spouse, and both of you are gainfully employed, then maybe you can reduce the emergency fund. And if you’re single without kids, you can probably skate by on the bare minimum 3 months expenses because if you lost a job you’re in a better position to really scrimp for a while, relocate for new work, or crash with family members until you find a new job.
Do you own a home?
Homeowners tend to have more (and more expensive) repairs to make that suddenly jump out of nowhere. If you’re a renter and the furnace goes out, you just have to call the landlord.
Ok, this sounds well and good. But I only have 81 cents to my name and am living paycheck to paycheck. How can I possible save a year of expenses in a bank account?
If you’re starting from scratch, have no fear! I don’t normally subscribe to personal finance gurus, but when it comes to budgeting and debt avoidance, I think Dave Ramsey is generally spot on.* Ramsey suggests first establishing a baby emergency fund, then paying down debt, then filling out a 3-6 month fund. For most people starting form scratch this approach works fine, though I might suggest saving more for an initial emergency fund. $1000 doesn’t buy much these days, especially when the you-know-what hits the fan.
Where to hide the emergency stash?
In selecting a bank or fund to hold your emergency fund, just remember that a proper emergency funds needs to be secure and it needs to be liquid. Don’t assume that your home equity is an emergency fund; that’s not always liquid. Even if you have a home equity line of credit (HELOC) (see below). And don’t assume that your shares of FB stock is an emergency fund; sure, you can sell it, but is it secure? Is it FDIC insured? I don’t think so. Once you’ve identified a few banks that are FDIC insured and offer cash or money market accounts, only then should you look for good interest rates. Remember, high interest rates don’t matter if its not liquid or secure. Unfortunately, until interest rates change you’re not likely to find much paying more than .8% or 1% interest these days. But remember, the point is not to earn a return, but rather to have money securely set aside for unexpected emergencies.
Some people set up tiered emergency funds trying to maximize their return while still keeping their money secure and liquid. For example, 3 months expenses in a cash account, 3 months in short term CDs, followed by 3 months in short term bonds. After you’ve established an adequate emergency reserve, feel free to explore some of these options. While I don’t try and tier my emergency reserve, I’m also not opposed to doing so, as long as its done wisely.
Cash vs. Lines of Credit?
Some people say you can use home equity lines of credit as your emergency fund. Unfortunately, you run huge risk doing so. Lines of credit, including HELOCs, can often be frozen with little notice. In fact, one of the common situations in which a bank may freeze your HELOC is when you lose your job precisely the time you would need access to your emergency funds. As described earlier, the most important characteristics for an emergency fund are security and liquidity, and unfortunately lines of credit are not always secure or liquid.
Roth as emergency fund?
Still others suggest using a Roth IRA as an emergency fund. I may do a whole blog post on this topic later on. Per IRS regulations, you can always withdraw your contributions (but not your earnings) from a Roth IRA tax and penalty free. While I think this is preferable to using a HELOC, its still not ideal. The ideal situation would be to have a cash emergency reserve in addition to a fully funded Roth IRA. But if you’re not able to do both (yet!), don’t fret. Feel free to use your Roth IRA to help fund your emergency reserve. In fact, some people even suggest that you might come out ahead in the long run using a Roth IRA for your emergency funds rather than a cash account.
Everyone, regardless of your work situation, family life, age, or income should have an emergency fund. If you don’t, what are you waiting for? Start saving! Even if its just $10 or $20 per week. Put whatever you can aside, and remember to keep it in a safe and accessible account.
*His investment advise, on the other hand, is a topic for another day.