Thanks for following the “How to Budget” series. We started a few weeks ago chatting about Why we budget and How to put a budget together. We looked at working through a budget when income is irregular. Now let’s consider building an emergency fund. An emergency fund isn’t really part of the budget so much as a tool to help you stay on budget and protect your financial health. You need an emergency fund!
Before we continue, I need to remind you that I am not a certified financial planner, accountant, or investing professional. I am a mother who learned personal finance from the “School of Hard Knocks” and is willing to share what she’s learned in the spirit of chatting with a friend over coffee. If you require professional advice, please seek it from someone with the appropriate certification.
What is an emergency fund, exactly? It’s a pool of cash that you can access quickly to help you deal with emergencies that might otherwise derail your financial plan. You should ideally have enough money set aside to cover at least 3-6 months’ worth of expenses in case of a total loss of income. If you have irreqular income, do seasonal work, or are in field that is subject to frequent layoffs, you may want an emergency fund large enough to cover 6-12 months’ worth of expenses.
An Emergency Fund is…
- For emergencies only.
- To cover expenses.
- Started quickly and then built over time.
For Emergencies ONLY
Tires pick up nails. Wind blows shingles off of the roof (Hurricane Ike!). Parents who live far away get taken to the hospital and road trips become necessary. Emergencies happen. But not every opportunity to spend money is an emergency. Birthday or Christmas gifts are not emergencies and should be planned as part of the regular budget. Restaurant meals are not emergencies and can often be prevented with a little pantry preparedness and car picnic supplies. A full emergency fund usually takes time to build, so it’s important to save it for true emergency needs and not blow it on wants. If you’d like to brush up on the difference between wants and needs you might read this post.
An emergency fund is not an investment in the sense that you’re looking for a good rate of return. It’s more like an insurance policy that is there if you need it but doesn’t do much if you don’t. Money designated for the emergency fund should not be kept in certificates of deposit, stocks, or other hard-to-access places. Park the money in a savings account or something similar. It needs to be a stockpile of cash you can get to in a hurry if and when life happens.
To Cover Expenses
If you should suddenly find yourself without income, your emergency fund could keep your household functioning until you’re able to find a new job. If you are wise, during the time of no income you will cut out unnecessary spending and use your emergency fund strictly for your needs. Given the change in spending priorities that should come during a time of reduced or eliminated income, you’ll need to plan your emergency fund to cover your expenses and not necessarily your full income.
For example, if my husband and I were to find ourselves without income, we would eat from the pantry and not buy extra groceries or go to restaurants. We would stay home a lot and my husband might even walk to work in order to avoid running gas out of our cars. We would cut spending wherever we could. We would not be tithing because we’d have no income from which to tithe. We would stop investing for retirement and setting funds aside for our children’s education. Those items would disappear from our budget until we found a new source of income. For these reasons, we would not need as much money as we normally do. Our emergency fund covers 3-6 months’ worth of expenses, not income. That said, having a larger emergency fund of up to 12 months’ worth of expenses is not a bad idea. Funds beyond that would probably serve you better if they were invested someplace that will yield a better rate of return because you’d already have 12 months’ worth of cash to live on, thereby giving yourself time to access the invested funds.
Started Quickly and Then Built Over Time
Once you are current on your bills, you’ll want to build up a small emergency fund of $1,000 – $2,000 as quickly as possible. Take an extra part-time job, have a yard sale, sell stuff online, whatever you need to do…just pull together that small emergency fund right away. Having that little bit of money in the bank will allow you to start paying off debts and maintain your momentum even when tires blow out or washing machines spring leaks. If you have a small emergency fund you can handle those emergencies without taking on more debt.
You can build up your full emergency fund once you’re out of debt, except for your house. Just add an “emergency fund” line to your budget and start saving money from each paycheck until the emergency fund is fully funded. Or get to a full emergency fund even faster by working overtime or taking on an extra job.
And if you don’t own a home, please don’t purchase one until you have a big enough emergency fund to cover a full 3-6 months’ worth of expenses. Any homeowner will tell you that things break and repairs are necessary, even in new homes. Trying to maintain a home without an emergency fund is no fun! Have a little patience, use your desire to own a home to help you focus on saving up that emergency fund and down payment even more quickly, and rest easier in your home knowing that you can handle what comes…at least financially!
A Final Note
Where you keep your emergency fund is up to you, but if you decide to use a financial institution to protect your emergency fund I suggest you keep a little bit of cash hidden at home. How much is up to you. The reason it’s a good idea to have a little cash on hand is that sometimes emergencies happen when financial institutions are closed. I’ve climbed in the car “after hours” to drive to a hospital in another state because somebody I love was admitted. Being able to grab some cash and go was much less worrisome than wondering if I could find an out-of-town bank machine. You can probably think of other situations that would be easier to handle if you had access to a few dollars. Please consider your unique life situation and plan accordingly.
Do you have an emergency fund? How has it helped you?
The “How to Budget” series posts are:
- How to Budget: Why?
- How to Budget: How – Part 1
- How to Budget: How – Part 2
- How to Budget: Irregular Income
- How to Budget: Emergency Fund
- How to Budget: Getting Out of Debt
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