Building an Emergency Fund
I’m sure that you’ve heard this before, but it bears repeating… When you’re getting your financial house in order, the first step should be to build up an emergency fund. The purpose of this fund is to allow you to navigate rough patches in your life without completely derailing your finances. Just be sure that you reserve it for true emergencies.
How large should your emergency fund be?
The ideal size of an emergency fund depends in large part on individual circumstances. Most suggestions range from three to six months of living expenses, although some experts are comfortable with less, whereas others recommend more. Yet others suggest a tiered approach, wherein you initially set aside $1,000 and then build up to 3-6 months of expenses once you eliminate your debts.
Of course, these sorts of recommendations assume that you have a basic idea of your living expenses. Assuming that you do, you just have to set aside the prescribed amount. Easy enough. Right? Well…
How should you go about building up an emergency fund?
Unfortunately, it’s not always as simple as dusting off your monthly budget, multiplying by three (or six, or whatever multiple you’re most comfortable with) and then sticking a bunch of money in the bank. In the vast majority of cases, it’ll take some time to come up with the necessary funds.
As with anything, the most important step is to just get started. While it may take longer than you’d like to build up your emergency fund, it’ll never happen if you don’t take that first step. If you can only afford to trim $50-100/month from your budget, that’s fine. Build it into your budget, and start transferring the money to a dedicated account at your favorite bank.
Another great strategy is to direct any windfalls that you receive into your emergency fund until it’s fully funded. Along these lines, perhaps the most timely advice would be to use your tax refund and/or your tax stimulus rebate check as the basis of an emergency fund — tomorrow is Tax Day, after all!
This article is part of the MBN Group Writing Project on emergency funds.
Published on April 14th, 2008 - 8 Comments
Filed under: Banking
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This is a good post. Everyone should have an emergency fund that they can use instead of their credit card. Most people use their cards because they don’t have an emergency fund. So instead of receiving interest on their emergency fund, they are paying interest in their cards, unless of course they pay it off every month. And less than 30% pay off their cards every month. That makes a huge difference in a household budget.
Comment by "Mo" Money — Apr 14th 2008 @ 10:28 amHaving an emergency fund is absolutely critical. I think it’s great how often it’s mentioned on the various PF blogs. It also provides an amazing amount of security/lack of stress knowing that there is padding.
Nickel, do you have any reassessment of the best way to “store” the emergency fund? With many money market rates down to around 3%, one is barely holding steady with inflation (ie, the real interest rate is 0%). Ours is still in a MM account but I am tempted to get more creative. One option is to dump the cash into one of our mortgages (primary residence, rental #1, or perhaps start rental #2) and then open a HELOC. Or simply dump the cash into the market and open a HELOC based off the existing equity. Obviously HELOC rates are variable and aren’t great but that would only matter in the event of a serious financial emergency. Otherwise the 4-6% interest costs avoided would outweigh the 3% the MM yields.
Comment by SomeGuy — Apr 14th 2008 @ 10:39 amAll of my emergency fund (about 2 mos. living expenses at our current expenditure) is in a money market. The rest of our emergency fund (about another months worth of living expenses) is in boring dividend-paying stocks. I know everyone will slap me on the hand and say “bad”. But here is my reasoning.
I have 2 months of current expenses in cash - but if one or both of us loses our source of income we will cut our current expenses down - so that 2 months will last at least 2.5-3 months. In the mean time we would be able to withdraw any money needed from stocks (although the timing of the sale might not be ideal) to supplement our income.
However the only reason I’m willing to be this risky with an emergency fund is that our jobs and income are very secure and we have sizeable savings above our emergency fund. I would not recommend anything but a money market or savings account for emergency funds involving people who have unstable incomes or don’t have job security (self-employed, contractors, etc). Those folks need to be quite conservative with their emergency fund and keep it very liquid.
To SomeGuy above - I can certainly realize your desire to put some of that emergency fund money to work, especially with interest rates so low. But take a look at your entire financial picture and talk to your wife about it. She needs to be comfortable with that move and women tend to be more conservative - they like a nest egg in the bank. But you both need to agree to it and it needs to be part of the bigger overall financial picture.
Comment by KC — Apr 14th 2008 @ 10:56 amWe started with an emergency fund of $1,00o; however, it was quickly depleted when my husband had an irregular month of work. Out goal is to have three months’ expenses saved and I suggest others who are self-employed also aim for a baby emergency fund of at least a month expenses’ if possible.
Comment by Financial-Tip — Apr 14th 2008 @ 4:34 pmI completely agree — merely having several thousands on a credit line is not sufficient. It’s vital to have several thousand cash (yeah, cash, remember that stuff? stowed in an account for anything that may arise. Even if you still need to use some credit to cover the very end, that’s fine. But people who think a credit line is an emergency fund are doomed. The savings rate in America is pathetic — somewhere between -.5% and 2%. Thanks for this post! I wish more people would get with it and save. Do you really need that Starbuck’s frappuchino? No!
Comment by Emily @ Taking Charge — Apr 14th 2008 @ 6:01 pmEveryone thanks for the comments,
KC: Actually my wife is MUCH more financially aggressive than I am. The traditional role reversal goes a lot further than that believe it or not! Also, I lived through a job loss in the past and you should make sure you indeed can and will be able to quickly cut expenses in the event of such a loss. For example, we use a credit card for all possible expenditures and pay it off each month. We are essentially paying for last month’s expenses out of this month’s cash flow. If you lose your job this month, you could end up having to pay last month’s (presumably normal/higher) expenses on the reduced income. I HIGHLY recommend that you base at least the first jobless month’s expenses on your normal spend level, not a cut-back emergency level.
Emily: I will post shortly on my own blog (www.huntinghappiness.com) some intimate financial details which may help to change your mind. We are very fortunate in our financial situation. Our current cash on hand is over $100K. I actually haven’t tallied up available credit on cards but it is at least $90K, plus probably another $100K of tappable home equity covering two properties. I think the point I’m trying to make is that $100K+ cash has a real return of 0%. Using it to pay down the mortgage is pretty much a guaranteed 4-6% real rate. Investing in another rental is higher risk but substantially higher potential reward. We would still have available credit cards to cover several years worth of expenses, and that is assuming we both lost our jobs. Now on the flip side there is something very comforting about knowing either one of us could walk out tomorrow and go for a long time before incurring any debt.
Comment by SomeGuy — Apr 14th 2008 @ 6:30 pmIt’s very crucial to have an emergency fund and the sooner we start saving for it the better it is. But what I feel is at a crisis all funds that we have turn into emergency funds. During bad times all we need is money no matter from which fund it comes.
Comment by Kelli Myers — Apr 18th 2008 @ 3:02 amHey Nickel, I like your tip on putting a tax refund towards an emergency fund. Great read, overall. I recently wrote a piece about emergency funds at RBCp2p - a blog for students by students - and linked to this entry of yours.
If you’d like to see the entry I wrote, you can see it at http://blogs.rbc.com/rbcp2p/20.....nds_1.html
Cheers,
Comment by Nick Simard — Apr 23rd 2008 @ 1:25 pmNick
RBCp2p