How Emergency Funds Work

How Emergency Funds Work

An emergency fund is practically self-explanatory. Its money put aside in case of hard times that may arise. It’s for those things you don’t want to think about and can’t plan for but could happen in the future. This could be something like if your car were to break down, unexpected medical bills, home repairs, or sudden unexpected unemployment to name a few. The reality is that you’re going to experience these things at some point in your life and if you aren’t prepared for them financially, they can become much more painful than they need to be. You don’t want to have to ask friends for money, access payday loans, rack up your credit card debt, or tap into your retirement.

So how much money should you keep in your emergency fund? Well the minimum recommended is about three months’ worth and up to as much as twelve months. Any more than that is a bit excessive and you should really be investing it so that the money can work for you. There are factors that you should consider in determining how many months’ worth of expenses you have set aside. Things like job stability, the number of incomes in your household, and homeowners versus renters. The more stable and predictable your expenses and income, the less funds you’ll need to maintain in an emergency fund.

A three month emergency fund is not simply three months of your current expenses. You may spend $2000 dollars every month including rent, utilities, food, transportation, vacations, travel and entertainment however when you calculate emergency expenses you are calculating the necessities so you won’t include things like vacations, travel and entertainment. In other words if you spent $500 per month out of that $2000 for vacations, travel and entertainment, we’re actually spending $1500 per month on the necessities so we multiply that by three and arrive at $4500 for our three month emergency fund. The reason for this is that when an emergency arises, you should cut back on some of your optional expenses to ease the financial strain. This means you’ll cut back on eating out, movies, vacation etc.

Where you store your funds is a very important aspect of your emergency fund. It should be readily accessible and liquid without penalty’s or hoops to jump through. You’ll need access quickly so you can’t just count the equity in your home, your vehicle, retirement account or your mutual funds. You don’t want your emergency fund to be invested in the stock market because if you’re forced to withdraw it in a down market (which is often when you most need to tap into it) the size of your emergency fund would be significantly reduced. So the best place is somewhere like a checking, or savings account.

The emergency fund will give you peace of mind and prevent you from spiraling out of control when unexpected expenses arise. You don’t want to live paycheck to paycheck without room for a single additional expense; this is a recipe for disaster! Once you setup your emergency fund, don’t touch it. Your alpine skiing vacation is not an emergency. So calculate and then establish your emergency fund today. You’ll sleep better knowing you’re prepared for your future.