Financial Advice Blog

Emergency Fund 101

by Community Manager  |  San Antonio, TX  |  ‎04-28-2014 08:15 AM

Rainy Day Change Jar - shutterstock_115555501.jpg

 

Your grandmother may have called it a rainy day fund. Financial professionals typically call it a cash reserve or emergency fund. Whatever its name, the purpose is the same: having some money set aside for when the unexpected happens so that you don't have to sell things or go in debt to deal with it. And while the concept is fairly simple, there's more here than meets the eye; starting with what is meant by "some money" and "set aside."

 

How much is enough?
The generally accepted rule of thumb for your emergency fund's size is that it should equal at least three to six months worth of your committed monthly expenses. Why this amount? Well because one of the primary reasons to have an emergency fund is to keep you afloat financially if you should suddenly experience a loss of household income.

 

But protecting against lost income isn't the only reason to keep a stash of cash. It's also important to have money available to pay for unexpected expenses that your regular monthly cash flow can't cover. Even if you feel your paycheck is secure, bad things do still happen to good people and sometimes those things require cash. As a result, the amount of money that should be set aside (but not the need for having it!) really depends on the life situation and circumstances of the individual putting it away.

 

Where to save it?
Then there's the question of where to put it. Does it all go into savings? Can you use CDs? What about using "conservative" investments? The answers are: maybe, yes and no. The bottom line here is that since you have no way of knowing when an emergency will occur, you have no way of predicting when these funds will be needed. So your savings really should be accessible and not subject to market volatility. In other words, you need to be able to get the funds quickly and know they'll be worth as much as or more than they were when you set them aside. That typically means using savings accounts, money markets and maybe some short-term CDs for some of the money — regardless of how low the interest rates on these products may be.

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To pump up the returns a little, it's often a workable strategy to create a two-tier emergency fund; the first tier being savings or money markets and the second tier being a short-term CD. Keep this thought in mind though, when it comes to emergency funds, return OF principal is more important than return ON principal.

 

When to use it?
So what's considered rain? Clearly, a big car repair, an insurance deductible or an AC on the fritz during the hot summer months comes with a green light to tap your emergency fund. Life happens and your emergency fund will allow you to experience both good and bad without having to accrue debt or access longer-term investments. Finally, regardless of your strategy, it's important to systematically add to your emergency fund. That way, when you have unplanned expenses, you'll automatically be restocking it.

 

Whether you call it an emergency fund, cash reserve, or rainy day fund like Grandma did, this isn't your "Get Rich" money. It's your "Don't Get Poor" money. So set one up, and use it wisely.

 

 

 

DID: 136987-0212

Comments
by Brian.Robbins ‎05-15-2014 01:30 PM

Great summation. I think there should be an addendum to this though... When NOT to use it. This can be just as powerful as when to use it as well. For example, Christmas and birthdays aren't emergencies. They happen at the same time every year and we should be ready for them regardless. Keep a seperate fund for "presents" and another for "maintinence" (car or home). Having these foundations before the 3-6 months of expenses can go a long way toward eliminating non-emergencies and using the emergency fund for true emergencies. 

by Community Manager ‎05-15-2014 01:32 PM

Completely agree, Brian! Thanks for the follow-up thoughts! -Scott

by Dave Ramsey Owns Me ‎05-15-2014 02:01 PM

This seems like sound advice, but my question remains. Do I pay off debt before or after building the emergency fund?  Or, is there some happy combination of both?

 

 

by Community Manager ‎05-15-2014 02:20 PM - edited ‎05-15-2014 02:21 PM

When trying to get out of high-interest, consumer debt it's important to first establish at least a small emergency fund - perhaps $1,000 or so - to allow you to handle any unexpected expenses that come your way without adding to your debt levels.

 

As you're building this small reserve, you'll typically want to make only the minimum required payments on your debt. Then, once you've got it funded you can redirect your excess money each month to knocking down the debt. As you use the emergency fund dollars though, just be sure to replenish them.  Once the debt is all gone then you can shoot for the full goal of 3-6 months of expenses.

 

Hope that helps!

 

Scott

by Shenkbri ‎05-15-2014 02:51 PM
I don't agree that the savings should be started before you end your debt. Remember, not owing money is the same as having it. Basic arithmetic. If you have $1 but owe $5. You really have negative $4. And if you're paying 18% interest, it's getting worse every month. I was once $10,000 in debt with no savings. I eliminated my debt and now have six months living expenses saved. It really makes no sense to pay to exorbitant fees and interest to stockpile money that you may need. You're only making yourself poorer. Pay debt first, them save. If you get bonuses at work, apply 100% to your debt until it is eliminated.
by Community Manager ‎05-15-2014 03:09 PM - edited ‎05-17-2014 05:33 AM

I completely get where you're coming from Shenkbri and I agree that on a purely financial level, it makes no sense at all to save money at near zero interest rates when you're often paying double digits on the debt. Having said that, it's also important to understand that, for a whole bunch of people (not everyone though), both getting into debt and getting out of debt is less about interest rates and more about behavior. In other words, though the interest rates can make it difficult to get out of debt, interest rates aren't typically what put them their in the first place; behavior is. (Now..before anybody goes on a rant, I totally understand that consumer debt isn't always the result of bad behavior. Sometimes it's just bad luck.) Anyway, for many people the behavioral aspect of saving and then being able to use cash is often just what's needed to break the cycle of debt use. For those who don't need the psychological boost of the cash account, I agree with you completely. 

 

Thanks for weighing in! The more different perspectives people hear, the better!

 

Scott

by rllarson ‎05-15-2014 05:47 PM

If you are getting out of debt you need the emergancy fund more than paying down the debt. but the emergancy fund is $500- $1000 Just enough so if you have to repair your car, fix your hot water heater, get some medicine or pay an insurance deductable t without resorting to the Credit cards.  then pay down the debt on any credit cards and such after that then you make your  6 month emergancy fund. In matter of fact the $500-$1000 should not be included in the 6 month plan in my opinion. then after the 6 months you can try and work up to a year. just because many people during the last recession were unemployed for a long time.

by Mingle ‎05-16-2014 04:34 AM
What is your opinion on maxing out IRA contributions vs. building an emergency savings?
by Community Manager ‎05-16-2014 04:57 AM - edited ‎05-17-2014 05:34 AM

Hi Mingle. Saving for retirement is very important but unless you're talking about an employer-provided retirement plan with a match (and even that can be debated in some situations), I'd tend to suggest building up emergency funds before diving too deep into retirement savings.

 

It's very important to have a solid foundation in place so that you'll actually be able to leave retirement money as retirement money (and not have to cash it out).

 

That foundation consists of 3 main elements:

 

  1. A spending plan or budget that keeps you spending less than you earn and saving money.
  2. An emergency fund.
  3. Adequate insurance coverage to protect you, your family, and your stuff is something goes wrong.

Ideally we'd like to be able to both long-term and short-term savings at the same time but if your situation doesn't allow you to do both it's usually best to focus on the short-term first while striving to be able to save for the long-term as well.

 

Thanks for the folllow-up!

 

Scott

by Wingnut82 ‎05-16-2014 12:56 PM
I've been using both my savings account and a secured credit card as an emergency fund. What do you think about using a credit card that is secured by a 2 year CD for this purpose?
by Community Manager ‎05-16-2014 01:27 PM - edited ‎05-17-2014 05:35 AM

Thanks for the question Wingnut82. Though it's your money backing the secured card, I'd probably still urge you to view the secured card more as a credit card not as an emergency fund. Here's why. If you end up not being able to pay off the balance each month, you'll be charged interest. Also, I like to see people get to the point where they no longer have to use credit cards (secured or not) for anything. Until you put yourself in a position where you can always pay for things with cash, pulling out plastic can be a hard habit to break.

 

Thanks again. I hope this helps!

 

Scott

by mjhannaman ‎05-17-2014 07:02 AM

Wondering how much is too much to put into an emergency fund, specifically in regards to having outstanding alimony payments to make.  I have just over 2 years worth of alimony left to pay off, and have adjusted my emergency fund accordingly to account for this, stockpiling a 12+ month emergency fund in excess of $125K.  Is this going overboard?  I wonder if I should diversify some of these funds into low-risk CD's or bonds, because right now its all cash.  I've read about using a CD ladder as a relatively low-risk approach.  My inner security, however, hinges on maintaining liquidity, but I can't help but wonder what I'm missing out on with all this excess cash lying around.  Any suggestions?

by cadets91 ‎05-17-2014 07:37 AM

I was in this situation because of a work injury.  I had to put a lot on my credit card, and chose not to use my emergency fund, but paid the card off over 6 months, but it was nice to know I could have paid it off if needed.

by Arnoldrules ‎05-17-2014 08:30 PM

Single most important thing for people struggling with finances and living paycheck to paycheck. 

by Metaforge ‎05-18-2014 10:39 AM

I also agree that even if you are trying to pay off debt, having an emergency fund of at least $1k-$2k is important to keep on the side.  You never know if something extreme is going to happen, and you do have the option in an extreme case to walk away from or even renegotiate your credit card, as it is unsecured debt.  Yes, it'll tank your credit score, but I'm talking extremes, and in an extreme case, you will want to have that bit of savings to put food on the table, because if you do walk on debt, you're not going to be getting a loan from anybody for a while.

 

Second, I think it's important to point out that CDs are still regulated instruments, and as such are not completely available at any time.  For example, consider that people who had money in CDs during the 9-11 attacks could not get at their money for a while.  This makes me shy away from them, at least at the beginning of setting up an emergency fund.  Most of it should be in a good old fashioned savings account at a bank where you can either walk into a branch locally, or get at it via any ATM (like USAA).  Personally I also believe in keeping some percent of your emergency fund on hand as physical cash - in a secure location of course.  That way even if there is a "banking holiday" someday, you still have access to some of it right away.

by Community Manager ‎05-19-2014 05:19 AM - edited ‎05-19-2014 05:23 AM

Thanks for the follow-up, mjhannaman! I LOVE that you've taken the initiative to set aside not only your emergency fund money but also what you’ll need to cover your alimony obligation. Now that’s taking it up a notch!  Having said that, I do believe your inclination is correct – you’ve probably gone a bit further than you needed to. 

 

The challenge now though is that since the alimony money will be used up in the next 2 years, there’s not a lot you can do with it…especially if you don’t have a high risk tolerance when it comes to these things. My guess (and it’s just a guess because I don’t know enough about your situation) is that a CD ladder is about as aggressive as you should probably get with some of these funds. In today’s interest rate environment you won’t earn a lot more even taking this approach, but it’ll at least beat the near nothing rate tht savings accounts are paying. To your point though, just be careful not to tie up too much and put yourself in a bind where you need the money but it’s not yet available.

 

Thanks again!

 

Scott

by TaterHater ‎05-19-2014 10:16 AM
Well said, sir. Plus, for those that are married, that emergency fund will provide a heightened sense of security in your spouse. It's always better to come home and be able to say "sweetie, I was laid off... But we also have $15k in the bank!" It gets rid if a lot of the stress and panic
by gilroygal ‎05-20-2014 11:28 AM

One more thing about the emergency fund...for my husband and I, it gave us a sesnse of security while we were getting out of debt. We knew that we would at least be able to afford a small emergency without having to use our creidt cards. Needless to say, we paif off over $15,000 worht of debt in 8 months due to be very disciplined and having a budget. Meanwhile, we knew that if a tire blew or what have you, we had money set aside to pay for it. At this point, we're putting away an emergency fund and a sinking fund. We need to have both because the sinking fund will cover future repairs to the house that we can plan for, and the emergency fund will be just what has been stated in previous posts. Since we bought a fixer upper, there are upgrades that we would like to do without incurring any debt. Great discussion!

by krammo9 ‎06-28-2014 05:37 AM

@ Scott or anyone else.

 

My wife and I do have a small reserve fund saved up and eevry check I continue to build it up. What is the recommended amount or percentage that should go into your reserve fund whether its monthly or every paycheck (every 2 weeks). Thanks in advance

by Community Manager ‎06-30-2014 06:40 AM

Scott is out on vacation, so I'll let him chime in when he gets back to the office, but my thought would be once you have the bare bones minimum (we've used $1,000 in this discussion) in place, systematic additions of 5-10% would work well.

 

And that automatic addition is something I'd recommend you keep in place...even when you get to the point where you have your target amount.  That way if you use the emergency fund it will automatically refill and if you don't you can periodically take the "excess" and shift it to other longer term accounts/investments. Good luck!

 

JJ

by Community Manager ‎07-02-2014 07:30 AM

Hi krammo9!  I'm back and I agree with JJ!  

 

As he mentioned, once you get to your target balance in place it's often a good idea to keep some level of automatic funding going. The remainder of you monthly allocation could then be directed toward longer-term saving like retirement or other goals you might have.

 

Thanks for the follow-up!

 

Scott