Great. Your car won’t start. After several hopeless attempts, you call the tow truck to haul it to the mechanic. They give it a once over and tell you the fuel pump needs replacing. Now, there’s one of two ways you can react to this. And it all depends on whether you have one thing: an emergency fund.
If you have an emergency fund, then you’ll probably say, “Boy, that’s inconvenient.” But without one, you’ll probably be in full panic mode.
Indeed, the COVID-19 pandemic has made the need for an emergency fund very clear for many Americans.
But this begs a few questions when it comes to emergency funds. Here are some of the most common ones:
- What is an emergency fund?
- How much do I need in case of an emergency?
- Where do I keep it?
- When should I use it?
Good news! Today we’ll answer all those questions and more! But before we begin, I want to recommend a couple of resources for you.
First, I have to say that The Total Money Makeover by Dave Ramsey is one of the best personal finance books out there. In fact, much of my philosophy about money comes from this book! Therefore, I highly, highly recommend you check it out! And yes, he’ll teach you all about emergency funds as well!
But if you want a free resource, you can check out my FREE eBook! I wrote a 23-page guide on how to get out of debt that you can grab at no cost to you! Just enter your email below and I’ll send it right to you!
Now, are you ready to learn more about emergency funds?
Emergency Fund 101
What is an Emergency Fund?
First of all, emergency funds can have many different names. Your grandma may have called it a “rainy day fund.” That’s because you’ll typically use your emergency fund when things go bad.
Some people also call them cash reserves, a backup fund, or anything else. However you look at it, they all have the same purpose.
Essentially, an emergency fund serves as a buffer between you and unexpected expenses. Those expenses usually have some kind of impact on a major need in your life.
Therefore, it’s important to have a stockpile of cash to help you out whenever Murphy comes knocking.
Why Do I Need One?
Unless you have some kind of crystal ball, unexpected emergencies pop up all the time.
And guess what? Emergencies typically cost money. In some cases, they will cost you A LOT of money.
For example, let’s say you sprain your ankle while playing basketball with your friends. This results in a trip to the doctor, a boot, crutches, and visits to a specialist. All in all, this could end up costing you $500-$1,000 over the course of a couple of months.
If you have an emergency fund in place, then you don’t have to resort to borrowing money to survive.
But without one, you could find yourself up the creek with even minor emergencies.
Do you think emergencies will never happen to you? Here are a few that happened to me in the last two years alone:
- Sprained ankle: $600 (That story about playing basketball with friends…Yeah, that actually happened to me…)
- Injured eyes: $400 (Don’t ask…)
- Furnace repair: $365 (My wife really didn’t want to freeze to death in the middle of the night…)
- Fuel pump replacement and towing: $1,000 (The car ran fine just hours before the fuel pump went out…)
Sure, it stunk when all of those things happened (especially the eye injury…). But in reality, having an emergency fund turns emergencies into inconveniences.
How Much Do I Need in Case of an Emergency?
Good question! Truthfully, it depends on your situation, your goals, and your monthly expenses.
Not everywhere has the same cost-of-living. Nor does everyone have the same monthly expenses. Therefore, it varies from person to person.
If you follow Dave Ramsey’s baby steps, you’ll know that Baby Step 1 is to have $1,000 in a starter emergency fund.
Now, I know what a lot of you might think. $1,000 isn’t nearly enough! And you would be right.
But $1,000 isn’t meant to be enough. The reason Dave recommends $1,000 is to prep you for Baby Step 2, which says to pay off all debt except your mortgage using the Debt Snowball Method.
Also, consider the fact that 60% of Americans don’t have the savings to cover a $1,000 emergency. And if you don’t have $1,000, then I would say that’s a pretty good place to start!
Once you pay off your debt, Baby Step 3 is to have 3-6 months worth of expenses as a fully-funded emergency fund.
You could consider this your “fully-funded” emergency fund, meaning most emergencies wouldn’t cost you more than 3-6 months of expenses.
How much is 3-6 months worth of expenses?
Again, this depends on you and your situation. If your expenses are around $3,000 per month, then you should have a minimum of $9,000 in a 3-month emergency fund. A six-month emergency fund would be $18,000.
But if you live in a high-expense area like New York City, your expenses are likely much higher. Therefore, you’d probably need more along the lines of $20,000-$40,000 stashed away.
3-6 months of expenses vs. 3-6 months of income
One of the great debates of emergency funds is whether you need 3-6 months of expenses or 3-6 months of income.
Personally, I would just stick with 3-6 months of expenses. If you find yourself needing that money, you’ll most likely live a scorched-earth lifestyle anyway. And 3-6 months is about how long it usually takes to recover from most major emergencies.
After all, I would rather use that extra money to invest in retirement or for other financial goals.
However, if you find your cost of living increasing, it’s not a bad idea to beef up your emergency fund a little bit more.
Also, if you find yourself in a potential crisis, you’ll probably want to stash away as much cash as you can.
Where Should I Keep My Emergency Fund?
The best place to keep your emergency fund is in a high-yield money market or savings account.
Because in a money market account, the funds are easily accessible whenever Murphy shows up.
The money doesn’t necessarily need to be at the same bank as your checking account, but it’s fine if it is. Just make sure you can access the funds whenever you need them.
Also, I encourage you to shop around and see which banks offer the best rates!
Why not invest my emergency fund?
Repeat after me: Your emergency fund is NOT an investment.
I see a lot of articles out there saying that you’re losing money by not investing your emergency fund. These financial nerds do all these calculations to say that your emergency fund doesn’t keep up with inflation, therefore you should invest it.
Okay fine. If you want to get into a math war, let’s go! Let’s say You have $20,000 and for an emergency fund and you want to invest it. You invest it for one year and it gains 7%. Then you have $21,445. Not too shabby!
But wait, COVID-19 hits the next year and you lose 22%. By the way, you also lose your job and you need that money. You have to sell the stock and you end up securing a loss of nearly $5,000.
Now you have less money in the time you need it the most.
Here’s the reality, you need to have some liquid cash that doesn’t fluctuate with the market. Do you lose a little bit with inflation? Sure. But your other investments will make up for it.
All that to say, all those online nerds forget to factor risk into their calculations. They run their numbers on the assumption that nothing bad will happen.
Trust me, just stick to a savings or money market account. It will be fine.
What about CDs?
Sure, go ahead and hide your money in your Guns N’ Roses Appetite for Destruction case! Oh wait…wrong CD…
CD in the banking world stands for Certificate of Deposit. Basically, the bank gives you a guaranteed rate of return for a specific period of time. Once the time period is up, you have the option to renew or withdraw.
However, these days the returns aren’t so good. Most of the time, you might get somewhere between .5% and 1.25% for a five-year CD.
Conversely, you can find online Money Market accounts with a 1.5% interest rate or higher.
Plus, most CDs also have an early withdrawal penalty. That means you’ll lose a chunk of money if you take it out before your term us up.
Therefore, I don’t recommend putting your emergency fund in a CD. Again, just stick to a Money Market or Savings account.
When Should I Use My Emergency Fund?
So, how do you know what constitutes an emergency? When should you actually use your emergency fund?
Truthfully, my wife and I have never had to dip into our emergency fund. Remember all those emergencies I mentioned earlier? Instead of going straight to our emergency fund, we just made sacrifices and changes to our budget.
Sure, your emergency fund is there in case of emergencies. However, I recommend using it only as an absolute last resort.
Also, here are some things that are definitely NOT emergencies:
- Coming up short on a major purchase
- Not planning ahead for Christmas
- Replacing broken electronics
- Booking a vacation
Of course, that’s not an exhaustive list, but you get the point. Those things aren’t emergencies and you shouldn’t dip into your emergency fund for them.
Now, here are a few things that you could consider a true emergency. However, you may also have the option to make changes in your budget without dipping into your emergency fund:
- Spraining an ankle or breaking a leg
- Replacing a flat tire
- Fixing a broken HVAC unit
- An appliance repair
Most of these will run you less than $1,000. Therefore, it’s best to see if you can cash flow these rather than dipping into your emergency fund. But it’s okay if you need to use your reserves.
However, you’ll definitely need your emergency fund for these major life events:
- A major injury or illness
- Job loss or reduced hours
- Death of a loved one
- Multiple minor emergencies all at once
Again, none of these lists are exhaustive. But you’ll need to slow down and think for a bit before you dive right into your emergency fund.
How Do I Start an Emergency Fund?
Now we’ll get into the real meat of how to start your emergency fund! Let’s go step-by-step into what you need to do.
1. Start with a budget
Surely you didn’t think I’d forget about budgeting, did you? Of course not! A monthly budget serves as the foundation for financial success.
When you budget, the first thing you’ll need to do is plan for your essentials. Those are:
Those are the most important pieces in your budget. After that, you can then plan for how much you want to put back each month for your emergency fund.
2. Save up your first $1,000
Once upon a time, I worked in a bank call center. I’ll tell you this upfront: it was one of the most miserable jobs on the face of the planet. However, I did learn something about the financial state of most people. The vast majority of my customers didn’t even have a savings account.
Is $1,000 enough for an emergency fund? No, no it’s not. However, if you manage to get $1,000 in savings, you’re doing better than 69% of Americans.
In other words, stop making excuses. Get that first $1,000! Once you do, the peace it brings may surprise you!
3. If you have debt, make a plan to get rid of it
Do you want real financial peace? Then you need to get rid of your debt. Period.
On average, Americans pay $951 per month on debt. And no, this doesn’t include mortgage payments. Some of you may pay even more!
Once you do that, start working on a plan to get out of debt. For real, pay off all that debt except for your mortgage.
I’ve mentioned this before, but I’ve written an eBook to help you out. Just enter your email address below and I’ll send you my free 23-page eBook on how to get out of debt. Seriously, it’s totally free and gives you a step-by-step guide on discovering financial freedom.
4. Once you’re out of debt, build up an emergency fund with 3-6 months of expenses
Now that you’re debt-free (woohoo!!!), keep the momentum going and build up 3-6 months of expenses.
Why wait until after you’re out of debt to do this? Because you’ll likely never build up your emergency fund unless you get out of debt first.
Debt can severely restrict your cash flow. Let’s say you bring home $4,000 per month. If you have $1,200 per month in non-mortgage debt payments, what’s the likelihood you’ll save up 3-6 months of expenses?!
At that rate, it would take you a few years to save up those expenses. But if you work a plan, make sacrifices, and pay off your debt, you’ll find you can save up 3-6 months of expenses fairly quickly.
Are You Ready to Start Building Up Your Emergency Fund?
As the old saying goes, the ball’s in your court. Now that you have the tools, are you ready to start building up your emergency fund? Or are you going to sit by and do nothing?
Sure, getting those 3-6 months of expenses will be hard. But you know what else is hard? Not having money when an emergency strikes.
Therefore, you have a choice. You can do the hard thing of building up that fund now. Or you can do the hard thing and have no money when you need it later.
So, choose your hard thing. But remember, one has a greater reward than the other. One leads to peace, while the other leads to difficulty.
You can do it! Build up that emergency fund and discover true financial freedom!
And of course, feel free to explore my Resources for inspiration and guidance!