Most people have heard of an emergency fund before. Especially if you read the title of this post. An emergency fund is pretty much exactly what it sounds like. It is a fund of money set aside to be used only in the event of an emergency.
There is a ton of advice floating around the internet regarding emergency funds. How much they should be. Where you should keep them. I’m going to add my two cents (which are pretty worthless….) into the conversation.
Let’s dive a little bit deeper into what an emergency fund should be before going into specifics. Around 40% of Americans would not be able to cover an unexpected $400 expense without borrowing money in some way (credit cards, family, etc.). The good news is that that is a smaller percentage than previously. We are at record low levels of unemployment which may explain some of the decrease. The bad news is that 40% is still too high of a percentage. Couple that with the fact that it may increase if the economy moves into a recession, and it is a pretty scary situation.
The basic purpose of an emergency fund is to make sure you are one of the 60% who can handle an unexpected $400 expense. I believe an emergency fund should go further. An emergency fund should help keep you out of debt even in extremely difficult situations, like losing a job.
There should be two stages of an emergency fund. The beginning stage should take the highest priority. The purpose is to give you the ability to start building financial freedom without a single unexpected expense knocking you back to square one. I recommend a fund of $1000. This should cover a large number of expenses, and you should build this fund first and foremost. If you have debt, consider the $1000 emergency fund as step one to killing your debt emergency.
Stage two of the emergency fund should occur after you are out of debt (excluding a mortgage). In this stage, you build up enough funds so that the loss of a job doesn’t ruin you financially. In this case, I can’t give you a perfect number to strive for. Many will recommend saving enough to cover 3-6 months of spending. I think that is great advice. Like anything though, it’s not perfect. If you share finances with another person who is working, but both of you live off of only one income, your emergency fund can probably be less. In that case I would recommend protecting against a medical emergency. Build up enough savings to pay your max out of pocket healthcare costs. While the amount can vary, the goal should be the same. Protect yourself and your family in the case of a bad, but not impossible, situation. We don’t have enough set aside to cover our house burning down, our car crashing, both of us losing our jobs, and me breaking my leg in a single week. But we do have enough to cover all of our max deductibles with a bit to spare. Evaluate your situation and pick a number that makes sense for you.
Now that we’ve established some numbers, let’s talk about where to put this money. This one is pretty simple. A savings account. You need to be able to access the money at a moment’s notice. You also need the money to maintain its value no matter what. This eliminates most investments, as there is always a risk you could lose that money, especially in the short term. Some people may keep their emergency funds in a money market account, or bonds, both of which can make sense if you know what you’re doing. For the majority of people a simple savings account will do. Always make sure to shop around and look for the best savings account interest rate. The top savings rates as of Feb. 2020 are around 1.9%, so you should be targeting at least 1.5% with your savings account.
One last thing. What should you use your emergency fund for, i.e. what constitutes an emergency? Is it that the new iphone just came out and it would really improve your quality of life? Or maybe to buy the new apple watch? Based on their commercials the heart rate monitor in it will save your life one day, that must be an emergency. Obviously those are not emergencies. An emergency is unexpected. It’s something you didn’t budget for. If you take my advice with budgeting, this means that even minor car repairs should not be considered emergencies. Here are a few things I’d consider an emergency:
-A car or home insurance claim requiring you to pay your deductible
-An unexpected medical expense
-Major car repair, potentially requiring a new-to-you car
The point is that this fund is meant to give you security on your pathway to financial freedom. It can be really difficult to build even $1000 in savings, so it shouldn’t be spent lightly. If you have to spend your emergency fund, your goal should be to build it right back up as quickly as possible. Eventually, as you increase your financial literacy, saving 3 months worth of expenses will become easy. And then you’ll be able to start using your extra savings to your future benefit in the form of investing.