Unfortunately, bad stuff happens from time to time. Your car breaks down, a medical emergency comes up, something on your home requires repair. These problems rarely provide much notice and thus escape the usual process of budgeting and planning. Instead, they present themselves (at the most inopportune time) as a large bill with little alternative but to pay. Sometimes, the amount on the bill contains a comma. Depending on your preparation, this can be either a nightmare or a small bump in the road.
By definition, these events are mostly out of your immediate control. As such, you can only control how you prepare for them and how you react to them. Creating an emergency fund (I keep mine at ING Direct) is a smart way to be ready for life when it hands you lemons.
What is an emergency fund?
An emergency fund is easy to understand but takes discipline to implement. The concept is fairly self explanatory – it is an amount of cash that is spent only on emergencies. There are two key parts to this definition:
- Cash – this implies that there is actual money in the bank, ready and waiting. Over time, this can be built up by monthly contributions. This requires that present consumption be reduced in exchange for future stability.
- Spent only on emergencies – a pile of cash sitting in the bank is tempting. However, this fund cannot be squandered but used only for emergencies only. And to be clear, that new pair of shoes or last minute trip to Vegas do not constitute emergencies.
Those stuck in a continuous cycle of debt often suffer from 1) overspending and 2) a lack of an emergency fund. The overspending prevents debt reduction, while new spending and interest adds to the total. Periodically, any break down / repair / large bill that occurs is paid with even more debt. This destroys any progress made paying down the debt. When a financial emergency arises, they are thrown back underwater, and the cycle repeats.
Benefits of an emergency fund
There are many benefits to having an emergency fund. Most share the common theme of ensuring future stability, which comes in many forms.
At its simplest, an emergency fund is a way of forced savings. Each month, you contribute money until you reach your target amount. Instead of spending, you are saving. Instead of sending money out the door, you are putting money in the bank. The confidence and peace of mind that comes with being able to handle financial emergencies is invaluable. For those serious about their finances, this is the first step to ensure stability and safety.
An emergency fund can also protect you from unemployment. If your job is your primary source of income, it will be very difficult to pay your living expenses if your job vanished tomorrow. The better alternative is to have savings in the bank that allow you to live comfortably for a time while searching for a new job. This would involve having a few month’s worth of living expenses saved, just in case.
Emergency fund strategies
There are various theories about how to construct your emergency fund. While the end result is an amount of money you keep in the bank, the deciding factors are critical as they force you to think. For example, in developing your own emergency fund, relevant questions may include:
- What financial risks exist (car repair, health care deductible, etc.)?
- Who are my dependents?
- What are my monthly expenses?
- How secure and stable is my income?
- What amount of money do I need to be comfortable/safe?
- What other investments/assets do I have?
Since every situation is unique, emergency funds vary in size. They can range from a few hundred dollars to over a year’s salary. I think somewhere in between is a happy medium. You want to be able to cover any of your deductibles without problem. Often times, you will hear these figures quoted in terms of living expenses. For example, I want to have 3 months living expenses in my emergency fund. This would cover a temporary job loss and provide a nice cushion of cash reserves.
Some may counter, “I could never save that much money”. My question to them is, “What do you spend your money on?” Each month, we make choices about where our money goes. It is up to us to insure that our desired future is aligned with today’s actions.
Setting a goal and taking action
After considering your own situation in terms of the criteria above, you can create an emergency fund by taking the following actions:
- Define your goal – This depends on your situation, and it can have multiple stages. For example, my immediate goal is to have $1k in my emergency fund (
completed June 2012). My longer term goal is to have 3 months living expenses in the bank, which is around $4k.
- Create an account – You can use any bank account for your emergency fund. I do not recommend keeping in your checking account (or under your mattress!) as it is too easy to spend. Instead, a free ING Direct account is great as it segregates the emergency fund, which makes it ‘official’. This also creates a barrier so I am not tempted to pull from it, although it is there if I need it. These accounts pay good interest and I enjoy their handy sub account feature.
- Automatic contributions – Using my ING Direct account, I created an automatic contribution that occurs towards the end of each month. This automatically transfers money from my checking account, and I don’t have to worry about it or remember it. It also prevents me from ‘forgetting’ to transfer the money. Savings and automation are key.
Best of all, this is something you can do in the next 15 minutes. Create an account, setup automatic contributions, and you are well on your way to a more stable financial future.