Job loss, medical emergency, transmission failure… you know what they say: when it rains, it pours. What they don’t usually say is when financial disasters strike, where you can get the money to cover these issues.
Ideally, you can take care of these expenses by using an emergency fund. An emergency fund serves the purpose of eliminating financial woes when something goes wrong or when the unexpected happens.
How Much to Set Aside in an Emergency Fund
Life happens! And an emergency fund can help you deal with things that your regular monthly budget just can’t. But how much money should be held in such a fund?
There is no universal answer. The amount to keep in an emergency fund is unique to a person's situation. Those paying off debt should consider a low emergency fund -- something around $1,000. This amount will take care of most of life’s emergencies that crop up, and leaves you free to put more money from your cash flow to debt repayment.
If debt levels are at a comfortable, manageable level (or if there is no debt at all), a bigger emergency fund can be put in place. Remember, there is no “right” answer when asking how big an emergency fund should be. It depends on your financial stability.
One question you can ask is, “how secure is my income?” The more stable the income stream(s), the less an emergency fund is needed. Most experts recommend 3-6 months worth of savings if income is stable.
Stable income typically comes from a full-time salaried position, long-term contracts, or many streams of income. Full-time salaried positions are pretty stable. Long-term contracts mean the money will keep flowing in as long as both parties keep the terms. And multiple streams of income provides more security, as if one dries up there are others to rely on before pulling money from savings.
Those who are self-employed may want to carry a larger emergency fund for peace of mind. Your business may need additional funds in a hurry. It could be because taxes weren’t paid properly, the business needs a new tool, or someone sues. Keeping 6-12 months’ worth of an emergency fund will work well for anyone worried about cash flow -- and that goes for you if you’re single, too, since you don’t have a second income from a significant other to fall back on.
Where to Keep an Emergency Fund
First and foremost, an emergency fund needs to be accessible. An emergency fund also should be relatively safe from economic risk, and, preferably, bearing interest. Think about a separate checking account, special savings accounts, or money market accounts.
If you’re not sure where to put your cash, consider trying an online bank. They generally offer higher interest rates compared with physical banks as overhead is lower. Many people also discover online accounts (or at least, accounts at different banks than their regular checking accounts) make them less tempted to use their emergency funds on non-emergencies.
It’s best to keep emergency funds separate from other accounts so the temptation to use them on non-emergencies is kept at a minimum. Don’t say, “anything above $3,000 in my checking account will be my emergency fund.” That’s dangerous. Instead, keep separate accounts. It’s easy to open a dedicated account and it’ll help keep things organized.
Think Carefully Before Investing Cash for Emergencies
Can it be done? Absolutely. But think long and hard before doing so. The problem is, if an emergency happens when the markets are down, a lot of money will be lost when you make your abrupt withdrawal. The initial $10,000 may only be worth $7,000 on the day of the emergency. Paying capital gains is also a concern.
Certificates of Deposits typically don’t make good emergency fund spots, either. If the money is needed before the CD matures, expect a hefty penalty. Added financial stress is the last thing you want to deal with when you’re already under pressure to deal with an unexpected situation.
When to Use Your Rainy Day Fund
Financial emergencies are usually situations in which you have no other means to handle the cost of the issue or situation. If you don’t have the cash flow to pay the expense or any accessible cash elsewhere -- or covering the cost would push you into (or farther into) debt -- you may want to use your emergency fund.
Keep in mind that overspending because you weren’t tracking your purchases for the month is not an emergency! That’s a financial mistake that you can (and should) work to correct. That’s trouble you create for yourself, and an emergency fund is designed to cover things you couldn’t see coming, didn’t expect, or had no control over.
Remember, it’s not a matter of if an emergency happens, it’s when. An emergency fund brings a person strength, assuredness, and peace of mind. They eliminate the financial stress so emotional needs can be cared for. Either start or reassess your emergency fund, and do it today!
Need a financial pro in your corner?