Emergencies are no picnic. There’s nothing like the dismay, panic and anxiety, followed by that rush of adrenaline to solve the problem. No solution can mean double the emergency. With finances, unfortunately one emergency often leads to another. A single emergency can be a huge setback for your financial freedom—unless you’re prepared.
What do you do in an emergency? Call 911. This blog helps you set up a “911 fund” that will be there when you need it
Understanding What an Emergency Fund Is For
An emergency fund is your cash cushion against loss of income or truly unexpected expenses.
Here are some examples
- You lose your job. Finding another takes time, but the bills won’t wait.
- You can’t work due to an illness. Even if with disability coverage, there’s usually an exclusion period of three to six months during which bills must be paid.
- Your car breaks down and needs extensive repairs. Large, unforeseeable expenses go beyond standard maintenance.
An emergency fund is not a substitute for poor planning. “I need to buy Christmas gifts,” isn’t a reason to call 911. Christmas comes each year, so plan and save for that. An emergency fund also isn’t a reason to make a big purchase on a whim because the advertisement says, “Act now!”
Calculating the Amount
Opinions differ as to how much should be in your emergency fund. I recommend three to six months of living expenses. However, it doesn’t hurt to have more. Some retirees keep two years’ worth.
Use your living expenses, not income, to calculate the amount. Do you know the total of your basic expenses during a typical month? If you’ve read my blog No Budget Way to spend Less 7 Save More, that’s what goes into your “Spend account” every month. My blog about uneven cash flow might help with irregular income and expenses.
Choosing Where to Put the Money
When calling 911, time is of the essence. Liquidity and safety are most important, so your emergency fund goes in the bank instead of a higher-interest investment vehicle. Sometimes online banks offer good returns (see www.bankrate.com).
Handling the Tradeoff with Debt
Your emergency fund comes before other priorities even if you have debt and want to pay it down. Before beginning any debt-reduction efforts, have at least a month or two of expenses in your emergency fund. Why risk plunging further into debt when an emergency fund can handle the unexpected?
Using Credit
If you’re suddenly strapped, a credit card might fill the emergency fund role temporarily. It’s not a good practice long term.
Some argue that good credit, a large home-equity line of credit and high credit-card maximums can cover for them instead of having a lot of cash in the bank. Be careful. Instead of relying on credit, get a three-month emergency fund first. Your good credit can be a second-layer backup to give you a total of six months. You must have cash in reserve, because it’s tough paying a mortgage with a credit card, and every credit card comes with a minimum monthly payment. Do yourself a favor: Get a cash cushion to avoid bad situations. It’s about balance.
Another second-layer backup can be a Roth Individual Retirement Account (IRA) if you qualify for one. Unlike other kinds of IRAs, you can withdraw the principal without taxes or penalties, subject to certain restrictions. However, don’t make a habit of pulling money out of your Roth IRA! Before considering credit or a Roth IRA as part of your plan for emergencies, you should have three months’ expenses in cash in the bank.
Avoiding Discouragement
If it costs you $5,000 each month to live, you need $15,000 to $30,000 in the bank. Don’t be intimidated by that. An emergency fund is not all-or-nothing. If you’re able to save a month’s worth of expenses, that’s one month toward financial freedom! You can increase your fund from there and work in saving priorities too. At three months you might put some savings elsewhere, then later build your emergency fund up to a full six months.
You can do it!