It seems like when you start talking about finances and saving money the concept of an emergency fund comes up. Losing a job or getting hurt and not being able to work is a possibility for everyone and an emergency fund is the perfect protection to help you get through that tough time. However, you may be shocked to know that, according to CNN, only 40% of U.S. adults can cover a $1,000 emergency expense. And according to Bankrate’s Financial Security Index 28% of U.S. adults have no emergency fund. Bankrate also says that only 18% of U.S adults can live for 6 months on their emergency fund!
Why do you need an emergency fund?
YOU CAN’T PREDICT THE FUTURE! You’ve heard the proverbial statement “life happens” and that is exactly what your emergency fund is for. Life’s unplanned expenses can range from a couple hundred dollars to thousands of dollars. If you were without an emergency fund then every time something unplanned comes up you not only put yourself further in debt by borrowing money, you also add stress to your life. By having an emergency fund you develop a peace of mind in that you have a built in insurance policy for your budget.
How much should you save?
The rule of thumb is that you should have six months of fixed living expenses. Fixed living expenses include mortgage, insurance, utilities, property taxes, vehicle payments & maintenance, continuing medical expenses, and groceries. The 6 month number can vary depending on factors such as the type of job you have and what other sources of income you have.
Some companies offer short term disability in the event that you get injured. For this case you will still have income (although typically reduced) and you may not need 6 months saved up.
On the other end of the spectrum maybe you work a W-2 job that doesn’t offer short term disability and you are the sole bread winner for you family. You will not only need 6 months’ worth of fixed expenses but also the unexpected expenses of raising a family.
Where do you store the money for an emergency fund?
You should store your emergency fund in a money market account. You don’t want to lose money out of your fund because the stock market goes down. You also want your money easily accessed so that you can get it when you need it and don’t have to wait for processing time (such as a CD or the stock market).
When should you use your emergency fund?
A good rule of thumb is if it is unexpected, necessary, and urgent then it justifies using money from your emergency fund. You should use your emergency fund to cover your monthly fixed expenses in the event that you become unable to work. You can also use it to cover unplanned medical or car repairs.
In your earlier years of accumulating wealth your emergency fund can be used for things that you shouldn’t use it for later in life. An example of that would be unexpected costs of owning a home. A new A/C unit, water leak, or a new roof are all examples of something that could use your emergency fund on in the early years. Eventually you can build something called a sinking fund that can cover items like that.
When you shouldn’t use your emergency fund?
Things you shouldn’t spend your emergency fund on:
- Vacation
- Planned medical procedures (braces or teeth whitening)
- Vehicle maintenance (oil/tire changes)
- Home projects (renovations, carpet, painting, etc)
- Clothing
- New vehicles
- College expenses
- Holiday or birthday gifts
Should you fund an emergency fund first or pay down debt?
Building an emergency fund is one of the most important things you can do when you first start you FI journey. You need to take a look at your budget and determine what you can cut out of it to help fund your emergency fund. If you have extra money at the end of the month and you are deciding whether to add money to your emergency fund or pay extra on some debt you should put it towards your emergency fund. Having a fully funded emergency fund will not only provide you peace of mind but could also prevent you from pulling out a short loan in the future in an emergency.
How to fund an emergency fund?
There are many ways that you can fund your emergency fund. A quick way to jumpstart your emergency fund would be to sell some no longer used (gently used) items on places like Craigslist, Facebook Marketplace, Fulfillment by Amazon, or Ebay.
If you are unable to earn more money from a side hustle then you need to take a look at how you are living your life and determine where you can live a little more frugal to free up some money. This requires developing a budget to limit what you spend and some sort of tracking system to determine what you actually spend your money on. Most credit cards perform the tracking function for you. BUT, if you are one of those people who can’t control themselves with a credit card then DON’T track your money that way.
You can also utilize direct deposit from work to put some money in to a separate account that isn’t a part of your regular spending. You can also take part of your raise and use the extra money to fund your account.
Take Away Points
- Building an emergency fund is part of the foundation of FIRE
- Only use your emergency fund if it’s unexpected, necessary, and urgent
- Store your money in a money market account. Any national bank will have them.
- You can fund your account by selling off unused items around the house, living a little more frugal, and utilize any raises from work.
