“Life is what happens to you while you’re making other plans.” Nobody really knows who said it first, but surely we can all relate: no matter how well you chart your course or how carefully you step, the unexpected is always lurking just around the corner.
An unfortunate event is usually dismaying, but when it strikes you in the wallet, it can also lead to consequences far beyond the immediate. This is why you need to be prepared, but how much cash should you really keep in your emergency fund?
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Risk Management for Dummies (or, Why Having an Emergency Fund Is Important)
It’s often helpful to think of your exposure to different types of emergencies both in terms of how likely each is to happen, as well as how severely each may impact your life. The following diagram is just an example; you can draw up your own reflecting your particular circumstances:
Another thing to consider is to what extent each contingency is under your control: with many, you can either mitigate the risk (e.g. drive more carefully) or reduce your exposure (e.g. buy insurance). At the end of the day, though, the fact remains that all the things you’re afraid of are either going to happen…or not. If one does, you’ll have to take action or potentially suffer further losses, some of which will not be financial in nature.
If you don’t have sufficient resources available to deal with the situation effectively, you may end up in a situation where you have no good choices and are forced to select the lesser of two evils. When a setback is both likely and serious, meaning that it falls into the upper right quadrant, you really don’t want to be caught short.
This is exactly why everyone needs to have an emergency fund: a reserve that gives you the means of keeping misfortune from turning into disaster. Whatever bad luck may strike you, having some cash available on short notice will probably save you a great deal of money, pain or both. An emergency fund is therefore different from a savings account or investment:
- It is the first place you park extra cash – saving for a new car or investing for your retirement can wait.
- It’s the last money you touch – even if you have to economize on groceries or take the bus because you can’t afford to fix your car this month, it has to be preserved for when you really need it.
- Despite the last point and unlike many investments, it also has to be immediately accessible. When you need it, you may really, really need it.
This is the most important thing to remember: your savings, emergency fund and investments are different things. Ideally, you won’t even think about your emergency fund unless you’re truly in a pickle
How Much Should I Keep in My Emergency Fund?
When it comes to preparing for the unexpected, saving “until I feel safe” is not a useful goal. People vary greatly in the way they assess and experience risk, so it’s best to keep emotion out of this decision and settle on a number. Once you’ve reached this goal, you would be right to celebrate: you’re now pretty much as insulated from ordinary life events as you can be. Your extra income can now be applied to saving up for the things you really want, including a more comfortable retirement.
Even if it will take you a while to accumulate enough money for a reasonable level of security, you should really make a start on your emergency fund as soon as possible. Any of the following can happen to you at any time – do you have enough in the bank to cover them? Unless you’re Warren Buffet, or at least a prudent saver, you probably can’t handle any possible contingency out of petty cash, but having even a hundred dollars salted away for emergencies will help you weather the storm that much better.
|Hospital Stay (per day)||$2,000.00|
|Automotive||Wind Screen Replacement||$200.00|
|Head Gasket Repair||$1,400.00|
|General||Repair Water Heater||$600.00|
|Consultation with Lawyer (per hour)||$200.00|
If you have the right type of insurance, some of these expenses won’t sting as much. Unfortunately, you’ll still be on the hook for the deductible, as well as out of pocket in the short term: even if you’re clearly not at fault in an auto accident, you may still have to wait 30 days or more for the claim to be settled. Medical coverage is a must-have, too, but there are some real horror stories about trying to get them to fulfill their obligations, while you’ll probably have to pay for any emergency, out-of-network consultations yourself anyway.
With all of this and figures like those in the table above, you should make getting your emergency fund up to at least $1,000 a priority (though you should probably work on clearing any high-interest debt, like a credit card balance, first). Ideally and eventually, most people should aim to eventually have between three and six months of living expenses squirreled away. To reiterate: this is your emergency fund – your ordinary savings and investment for retirement aren’t even taken into account here. Getting this amount of money together (and actually leaving it alone until there’s a crisis to deal with) may seem like a tall order, but you’ll most definitely be glad to have it when the time comes.
Depending on your circumstances, you may actually want to save more. We don’t want to dwell on the negative here, but remember that we’re talking about a worst-case scenario. You’ll certainly breathe a lot more easily once you’ve already prepared for bad things happening. Some aspects that can cause your finances to be more vulnerable, and therefore make a little extra preparation a good idea, include:
- Being self-employed, or working in any job where you won’t receive an income if you’re unable to work for an extended period.
- Working in an industry where layoffs in the near future are likely.
- Having a specialized skill set which, if you should lose your job, will make it difficult to get a new one at the same salary.
- Having children or other dependents (including pets).
- Having only one income in the family, the loss of which will upset the entire financial apple cart.
- Needing chronic medication; saving money by ceasing to take it will almost certainly do more harm than good.
- Not having an extensive support network of friends and family.
- Being highly dependent on continuity in any area of your life: absolutely needing a car that runs to work, for example.
How and When to Start Your Emergency Fund
Given that everybody is certain to suffer some kind of misfortune sooner or later, it’s surprising how few people are prepared for it. Only 41% of Americans have any kind of emergency fund at all. Their “plan”, such as it is, is simply to pay whatever urgent expenses they can’t avoid from savings or borrow, both of which cost extra money.
What is the antidote, and how do you get started?
Pay Yourself First
The best first step you can take in the right direction is to use a household budget to track your expenses. Drawing one up will not be the most entertaining hour you’ll ever spend, but the exercise is often enlightening. Once you know where your paycheck is going every month, you will probably see that you can indeed have some money left over after paying for essentials, even if this means trading imported beer for local and home-cooked meals for takeout.
Now that you can put a figure on your monthly surplus, you’re about to take one of the most important and worthwhile financial decisions you ever will: pay yourself first. Instead of just banking whatever money remains when your next paycheck arrives, you’re going to start saving deliberately. Whatever amount you can afford should go into your emergency fund (and once this is established, savings account and retirement investments) before you even start paying bills. If you don’t pay your (future) self first, any money in your day-to-day checking account is probably going to end up being spent on stuff you don’t need – this is simply human nature.
Under Lock and Key
Unless you have the willpower of an Olympic marathoner, it’s not sufficient just to tell yourself that you’ll remember to keep x dollars separate from your ordinary savings. You’ll need a isolated account only for real emergencies, or temptation will be staring you in the face every single day.
Luckily, you have a number of good options here. Just make sure to choose an account type that doesn’t charge any monthly maintenance fees, allows you free and instant access to your money at any time, and (ideally) pays you a little interest to keep up with inflation. It’s recommended that you set up an automated transfer to ensure your rainy-day treasury keeps growing.
- High-yield savings accounts are simple to understand and operate, and yield about 1% interest annually.
- Money market accounts offer better interest rates and also allow you to withdraw money by debit card or check. Most, however, require you to maintain a minimum balance.
- If you own a property, a home equity line of credit can be used as a kind of fake savings account. You will have to pay interest on any money you withdraw from it. Equally, your outstanding amount (and interest payments) will be reduced by stockpiling your emergency savings here. While you’re paying it off, the interest is tax-deductible
- Physical cash is not typically a good way to store money: it earns no interest and is easily stolen. Still, you may want to keep as much as a few hundred dollars in bills locked away safely. There are a number of scenarios in which you’ll be glad to have some hard currency available, including if your regular debit card should get frozen for no reason (as happened to me recently).
Using Your Emergency Fund
It’s important to build up your crash cushion as quickly as possible – disaster is hopefully not heading your way, but if it finds you, it’s not going to wait until the timing is convenient. Keep adding to it every month until you reach your goal amount, and put any windfalls like tax refunds and bonuses there before you think about buying a new wardrobe or creature comfort.
Now, if something bad should happen, you at least have a margin of safety. It’s at this point where many people’s good intentions break down. If you can’t stop yourself from depleting this cushion before you really, truly need it, you may as well not have an emergency fund to begin with.
Let’s look at a few different kinds of emergencies:
- Finding a good price on something you’ve always wanted,or having a rare but costly opportunity turn up,
- Unforeseen expenses you can’t cover out of your paycheck, like your car suddenly sounding like a heavy metal band,
- Larger problems like fixing a leaking roof, which will lead to even larger problems if left unattended, and
- For-real, honest-to-God emergencies like losing your job or having to go to the hospital.
The first scenario may not seem like any kind of catastrophe. Still, letting go of favorable circumstances because you can’t afford to pursue them involves opportunity cost – not taking advantage of good fortune may not cost you money, but it may well prevent you from making some. If you have to pass on the chance to interview for a lucrative job in another city because you can’t pay for the plane ticket, for instance, you’re trading a bird in the hand for a whole flock in the bush.
This concept – present versus future – lies at the heart of deciding when you should and shouldn’t tap your emergency fund. Ask yourself: “Will my health, net worth or earning potential be seriously impacted if I don’t spend money now?” In the case of an infected tooth and most home repairs, the answer is obviously yes. These kinds of situations are exactly why you need an emergency fund in the first place.
A broken washing machine when you can use a nearby laundromat, on the other hand, is not a true emergency. Telling your kid that you can’t afford to send them on a school excursion may be painful, but keeping them at home that day will not result in any major negative consequences over the long term. Repainting your house will indeed increase its resale value, but if you’re not about to put it on the market, it can wait a few months. Buying new tires for your car may be both urgent and important, but it’s not an emergency: you should have known this expense was coming and planned accordingly. It may be helpful to draw up a financial calendar called a cash flow forecast showing predictable expenses, so you’re never caught short.
How to Avoid Dipping Into Your Emergency Fund
It’s probably not the kind of thing you’ll brag about to your friends, but having access to a well-stocked rainy-day fund can be a pretty big source of pride. Especially if it’s earning interest, you may feel resistant to draining it unless you have to. You may also find that however much you’ve set aside for emergencies just isn’t enough, or be confronted with more than one problem at the same time. In either case, it’s important to be objective about the options you can use instead of, or in addition to, drawing on your emergency reserve.
- Find alternative solutions: If your washing machine won’t spin, you may be able to fix the problem yourself rather than calling in a repairman.
- Reach out to your support network: Nobody likes borrowing money and few people enjoy lending it out, but your friends and family may actually be happy to help you.
- Emergency assistance: Government programs like unemployment benefits and food stamps are worth looking into, but not something you should rely on. That $1,200 check certainly helped a lot of people out of a tight spot, but planning ahead for the bad times is really everyone’s own responsibility.
- Consider a loan, or use credit cards: If you need some money urgently but can pay it back in less than a month, a payday loan or cash advance on your credit card may be all you need to smooth your way.
- Check with your insurance: Very few people actually read and then remember the fine print of their policies. If your home becomes temporarily unlivable, for instance, your homeowner’s insurance company may be obligated to pick up the check for a hotel stay.
Shockingly, almost half of Americans wouldn’t be able to scrape up $400 in an emergency. It’s hard to imagine them sleeping well at night: knowing that you have a well-stocked emergency fund to fall back on will put an end to a constant source of mental tension you probably didn’t even know you had.
In other words, this is one statistic you don’t want to be part of, not only in case bad luck strikes but also because of the amount of worry it alleviates. The last thing you need during a crisis is worrying about where you can get the needed funds from. Having a safety net already in place will enable you to deal with the problem itself rather than the financial fallout, as well as save you money: borrowing or having to cash out long-term investments usually means paying extra.