When Should You Use Your Emergency Savings Fund?
Tip It!Emergency funds are a hot topic amongst financial writers. How much do you need? How should you go about building one? Where should you keep it? It seems like every time you turn around, people are writing about the importance of emergency funds.
Despite all of the attention paid to emergency funds, relatively little attention is paid to when you should tap into yours. With that as a backdrop, I thought I’d tackle the following question that I recently received from a reader:
What should an emergency fund be used for? I have read several blogs and some seem to think that it should be used in the event of unemployment. Some other bloggers suggested that it be use for things such as car repair, house repairs, etc. What do you suggest?
That’s a great question, and there really isn’t a one-size-fits-all answer. It really depends on how you’ve set things up, and how far you’ve made it down the path toward financial security. In the early stages, an emergency fund will mostly be used to cover urgent needs that might otherwise negatively impact you physical or financial well-being.
Take, for example, Dave Ramsey’s Baby Steps for getting out of debt. The first step is to build up a $1000 emergency fund. That way you won’t be forced to whip out the credit card when your car breaks down, the furnace stops working, etc.
Obviously, a $1000 emergency fund wouldn’t go very far if you lost your job. That’s why the typical recommendation is to eventually build up three, six, or twelve months of living expenses (Ramsey recommends 3-6 months in Baby Step #3). Such funds are obviously capable of sustaining you and your family for an extended period, and are thus typically used in the event of unemployment.
This isn’t to say that you can’t or shouldn’t use some that money when your car breaks down, but it’s important to build the fund back up after tapping it. Otherwise, it will gradually run down and won’t be able to sustain you when you really need it.
Of course, there are all kinds of answers in between. For example, you might have a main emergency fund with several months worth of expenses saved up, as well as “satellite” funds earmarked for car repairs, home repair, etc. If this sort of system sounds attractive, you might consider opening an account with ING Direct, as they allow for the easy creation of subaccounts accessible through a single login.
A couple of notes:
First, because of the importance of being able to access these funds in a pinch, you should keep them in a savings account or no penalty CD. Alternatively, if you have a fairly large emergency fund built up, then you might consider building a short-term CD ladder with your money spread across (say) twelve 12 month CDs.
Second, it’s important to recognize that certain things, no matter how inconvenient or uncomfortable they might seem, are not emergencies. In other words, if your car break down and you can’t get to work, that’s an emergency. But if your TV breaks down and you can’t watch your favorite TV show, that’s not an emergency.
Published on December 23rd, 2009 - 11 Comments
Filed under: Banking, Saving & Investing
About the author: Nickel is the founder and editor-in-chief of this site. He's a thirty-something family man who has been writing about personal finance since 2005, and guess what? He's on Twitter!
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December 23rd, 2009 at 9:14 am
I think a lot of these “rules” are silly. A lot depends on your job security. 3 months of expenses may be good for someone with a fairly secure job, but for those in certain industries, 6 months might be much more important.
It also depends a lot on your mindset. The goal of the emergency fun is to cover you in case something happens, but also to give you the peace of mind that comes with knowing that should something happen, you won’t have to worry about money. In a real emergency, the last thing you want to think about is how you’re going to pay for it.
December 23rd, 2009 at 9:55 am
Based on personal experience, I’d recommend 6 months. I was 31, healthy, in a very stable job when I was diagnosed with cancer. At the time, my benefits were great (they’ve since been hacked away) so that side of the financial piece wasn’t an issue, but I had no income for 7 months. (There were issues with getting short-term disability and by the time I was able to get that worked out — between chemo treatments — I was back at work. My lump disability check came later than my first paycheck when I returned.)
What’s the worst that will happen if you have extra? You won’t need it?
December 23rd, 2009 at 11:15 am
If your income is too low for your monthly expenses, then an emergency fund is not possible. You’re really only talking to people who are well off.
John DeFlumeri Jr
December 23rd, 2009 at 11:37 am
If your income is too low for your monthly expenses than you are living beyond your means. People do this with incomes of 20k and with incomes of 200k. Building an emergency fund is even more important to those that are not “well off”.
December 23rd, 2009 at 12:07 pm
My advice is to set your own boundaries for your “emergency fund” or whatever you want to call it. Then adjust your target amount accordingly.
If it’s going to replace your income if you’re unemployed (or not making anything if you’re self-employed), then figure out what is reasonable. Then if you’re also going to use it for car repairs, appliance repairs, etc. – increase it by a reasonable amount for those items.
No, it’s not as easy as just saying 3-6 months, but at least it will be more appropriate for your situation and your purposes.
December 23rd, 2009 at 12:22 pm
I’ve based my emergency fund on how long it will take me to get a job. As an accountant and a professional – I could be out of work for 6 months to a year. So, I’ve built my emergency fund to cover expenses for a year. If something were to happen to a car, I’m tapping into excess reserves, rather than my true emergency funds. Good post, thanks.
December 23rd, 2009 at 2:44 pm
I subscribe to the guidance in the book “Why Smart People do Stupid Things with Money” by Bert Whitehead. We keep a cushion in our checking account equal to 10% of annual household income – this covers things like emergency car or home repairs. Emergency savings should be 20% of annual household income, liquid (cash, CDs, Treasuries, TIPS) and kept in tax-advantaged accounts (Roth IRAs for those who qualify). The emergency savings are only to be used if money is needed due to a loss of income (job loss, medical leave, etc), the theory being if you have to take out your contributions and gains, the gains will be taxed at a lower rate, due to limited income. I like this setup because there’s an extra step involved in obtaining the funds — they’re not just sitting in my bank account for whatever feels like the emergency of the moment. Obviously, this won’t work for everyone, and it does take time for most people to build up liquid reserves of 30% annual income (we’re still building).
December 23rd, 2009 at 5:58 pm
@H Lee D: I was explaining to my wife what our savings goals are (she’s a bit new to PF) and she asks me what the emergency fund is for. My first response was “Hopefully nothing” because that fund is basically a net in case I lose my job. (She’s not working yet.) Planned expenses (house down payment, car replacements, etc) come from a different planning source.
@Matt: Interesting strategy. I assume your emergency funds are invested in some sort of stable value investment? You wouldn’t want them invested in securities and then lose your job when the market tanked.
December 24th, 2009 at 9:55 am
@Dan: Yes, right now the emergency funds are in a combination of short-term US Treasuries and TIPS index funds (volatility I am comfortable with). The next round of funding (2010) will be CD ladders set up in IRAs at my local credit union.
December 25th, 2009 at 2:33 pm
I was the original reader that ask nickel to post this topic. @ John people who make $20,000 can do this. That is what I make and I have come up with a plan to save a set amount out of my check every other week when I get paid. It is not much but I will eventually get there. I have also decided to put some of my tax refund up to do this. I have also opened 3 accounts at HSBC or some people even reccommend ING and 4 at my credit union so that I can separate my money for different purposes. I just started the check I got on yesterday, so I will let you know a year from now how it went. I am almost certain if I do my part by not touching the money, I will have $2000 of my own money saved this time next year. Just so you know we are on the right website for advice on financial planning, you may also want to check out frugaldad.com, greenpandatreehouse.com and suzeorman.com, kiplinger.com and cnnmoney.com I subscribe to all of these blogs and read them everyday and they are very informative.Sorry for the typos.
January 5th, 2010 at 6:04 pm
Interesting. You never see articles about when it is appropriate to raid the rainy day fund.