What would you do if your furnace died in the middle of the winter or if your car started smoking when you got in to go to work one morning? Most people would get the problem fixed and add the expense to their credit card.
Not a great solution, considering how many of us carry a credit card balance from month to month. Not only do you have an unexpected expense, but you are now paying 12-20% interest on that expense.
What to do about it? The answer is to establish a reserve to use in those situations. This is often called an emergency fund. The purpose is to be nothing more than a repository of liquid funds that can be used for unexpected expenses that cannot be put off.
How to start
It is important to start with what you can. Even just $50 or $100 in an emergency fund can make a difference. More than that needs to be the goal, but every dollar that you can put into an emergency fund is that much bigger of an emergency that can be handled without resorting to debt or other funding.
It can be as simple as depositing 1% of you paycheck into a new account to act as your emergency fund. That will grow your emergency fund over time, and if you can afford to save more than 1%, it will grow even faster.
Other ways can include cutting back on expenses and saving the difference or selling items that you do not need or use from around your house. If you want to quickly build your emergency fund, a part-time job also becomes an option.
The trick is to start with something substantial, sustainable or both. Once the emergency fund is started, you will have taken a positive, visible, concrete step towards getting or keeping control of your financial life.
How big
There are a lot of recommendation for how big your emergency fund should be. Numbers from 3 to 6 months of living expenses are often bandied about as appropriate for everybody. Others provide concrete numbers like $1000 minimum or $5000 or more. Yet, there is no magic number or formula that will work for everybody.
The real key to how big it should be is what level of emergencies are you likely to face and how prepared will you need to be to handle it? For example, if you are single, rent your apartment, and have no dependents, your emergency fund does not need to be very big. A couple of months of food, rent, and bills is likely enough.
Why? Losing you job is likely to be the biggest financial emergency you will encounter. Being on your own gives you the flexibility to get another job relatively quickly, even if it means moving to a different city or changing careers. All of this is dependent upon your having health care coverage.
A large family with a single wage earner is going to need a correspondingly bigger emergency fund. A few months of mortgage payments, food and bills will be helpful, but may not be enough. A death in the family, especially if it is to the wage earner, could have a more devastating immediate impact – even before any life insurance payments are received. Changing jobs and careers will be more difficult, especially if it involves moving to a different city. Six months of living expenses or more would be more appropriate because there are more emergencies that may need that much cash and it is more likely to have multiple emergencies in a small amount of time than for a single person who rents an apartment.
The rule to use to determine how much is needed for your emergency fund is to look at the most extreme emergency that you should be able to handle on your own. Include not only your own expenses, but the costs family and friends will have to bear during that time as well. Make sure to keep the handle on your own bit in mind. We can all envision a medical emergency needing a million dollar surgery that is not covered by insurance, but none of us needs to have a million dollar emergency fund.
How to continue
Once your emergency fund has been established, even if it is smaller than you want it to eventually reach, pause and look at your total financial picture. The starting fund should help you stay afloat while you work to make your total financial life as good as possible.
This may mean keeping a small emergency fund while you take care of other priorities such as paying off debt, establishing a retirement fund or paying off tax and court-ordered obligations. Having the small emergency fund makes it more likely that you can meet those priorities without having to borrow more money.
Once higher priorities have been taken care of, finish funding your emergency fund. Then let it sit. Do not touch the money in there except for emergencies, and once the emergency is over go back and refill your fund. Check on the fund once in a while to make certain that it is still big enough. As your life changes, the size of the emergency fund should change to match.
Where to keep it
So, you already knew the above information and have plenty of money for your emergency fund, or you are just starting one and want to know where to keep this fund. This is an important decision.
Ideally, the emergency fund needs to meet three criteria: 1) Easily accessible, 2) Safe, and 3) Liquid.
Easily accessible means that you can get to it when needed. Your emergency fund may be safe in somebody’s vault, but if it takes you three weeks to get into that vault, it is not good for an emergency. For the same reason, if you need money when traveling, storing your emergency fund under the mattress at home is a bad idea.
Safe means that the full amount is going to be there when you need it. You do not want to put your emergency fund in something whose value is going to vary over time. What happens if the value is down when you need the money?
Liquid means that you can get turn the fund into cash easily. Either it starts as cash, or it is a commodity that can be easily and quickly sold for cash as needed.
There are not a lot of places to store your emergency fund that meet all three criteria. The three options that work the best are money market accounts, savings accounts, and checking accounts. All of them are cash or can be converted into cash in a mater of hours. They are very unlikely to lose (or gain) much value over short or long term time periods. All of them can be withdrawn quickly from multiple locations.
Summary
To have emergency reserves for later, it is important to establish an emergency fund early on. This will work best as a checking, savings, or money market account. Once other priorities are taken care of, grow the fund to meet the greatest emergency you expect to handle without assistance. Then monitor it as your life changes to ensure it stays sufficient for your needs.