What is an Emergency Fund?
An emergency fund is a cash reserve that you have easy access to in case of an unexpected cost or a sudden loss of income. The emergency fund offers you insurance and peace of mind against unpleasant surprises. Basically, it is cash in a savings account that you don’t touch unless it is an emergency.
Examples of an emergency are a sudden need to repair your car or get a new refrigerator. Something that is essential to daily living that would put you into credit card debt if you did not have the cash on hand to pay for it. The other main emergency would be a sudden loss of income (ie. losing your job or being unable to work for an extended period). In this case, you would dip into your emergency fund to cover your monthly living expenses until your income resumes.
An emergency fund is NOT to be used for any other case. It is for emergencies only.
Why should I have an Emergency Fund?
In my opinion, there are three big reasons why you should have an emergency fund. Peace of mind, security, and freedom from debt.
- Peace of mind – an emergency fund offers you peace of mind because you know that if something unexpected comes along, you can handle it from a financial perspective without too much effort. The feeling of knowing you can lose your job tomorrow but will be OK because you have an emergency fund with 6 months of living expenses is liberating.
- Security – Having this cushion allows you the freedom to try things or to take more risks. Maybe you want to start working part-time and go back to school, or maybe you have the opportunity to leave your current stable job for a risky start up position that you’d love to do but has no guarantee of success. Having an emergency fund, especially one that is mature enough to cover your living expenses for several months, will allow you to take these risks in life.
- Freedom from Debt – If you are living paycheck to paycheck and suddenly you need to spend $800 on new tires or you can’t drive to work, that $800 bill will be a problem and likely put you into credit card debt. Now instead of those tires costing you $800, it is costing you $800 plus all the interest you have to pay to your credit card and any psychological stress it may have caused you. If you have an emergency fund, you simply take the cash out and pay the bill -done.
How do I Build an Emergency Fund
The first step is to get cash flow positive each month. In order to save any money, you need to have extra money each month to save. For more information on getting cash flow positive see the start here section or this post on the three basic steps to mastering your personal finances.
Once cash flow positive, your first goal should be to save $1000 in cash. This $1000 will go into a savings account that you have marked specifically for your emergency fund only. I use a high yield savings account at an online bank because it offers slightly higher interest rates than my regular bank. Direct all your excess monthly cash into building this emergency fund of $1000 first. This goal is very achievable and should be your first priority towards financial freedom.
After you have your $1000 initial emergency fund saved, set your next goal to be a minimum of 3 months of living expenses. Think about all your fixed monthly obligations and add to that a rough estimate of your variable expenses each month. Multiply this number by 3 and that is your next goal. While saving for this bigger emergency fund you can start to divert some of your monthly income for other savings goals as well. But the initial emergency fund should be a priority.
Finally, once you have 3 months saved up, you need to pick a long-term goal for your emergency fund. This long-term goal is completely up to you and dependent on your income stability/ job security and level of financial responsibilities. A good long-term goal is anything from 6-12 months of living expenses. Basically, at this stage, you will be saving for other goals, investing for your retirement, and putting some cash towards building your emergency fund for this long-term goal.
Using the Emergency Fund
If you ever have to dip into your emergency fund, make it your priority to replenish it back to its previous level before your start saving for another goal. For example, say you had to borrow $1200 for a new laundry machine from your emergency fund, then before you start saving cash for anything else you must put all your savings into your emergency until you have replaced that $1200.
An emergency fund is cash you have in a savings account that provides you with security and peace of mind in case of unexpected essential costs or a loss of income. Here are the steps to building your emergency fund
- Get cash flow positive so you can begin saving money.
- Set your initial emergency fund goal to be $1000, and save $1000 into a savings account.
- Set a goal of three months of living expenses for your emergency fund. Begin to both invest in your retirement and save for this bigger emergency fund.
- Decide on a longer-term goal for your emergency fund, set a number that represents 6-12 months of your monthly expenses. While saving for this continue to invest for your retirement and save cash for other goals.
For more personal finance basics check out the start here page.