This is a huge problem because everyone at some point has to deal with unexpected expenses of some kind. An emergency cash fund is one of the best tools in your financial arsenal to hedge against these personal black swans.
That way, if your home needs an emergency repair…
if your car breaks down…
or if you need cash to pay down a medical deductible…
or if you suddenly find yourself out of work…
you have a buffer to help you through lean times (and avoid the downward spiral of having to take on debt).
Here is what everyone should know about building and maintaining an emergency fund.
How Big Should My Emergency Fund Be?
Your emergency fund should be able to cover six months of living expenses. This is essential expenses only, not income. You shouldn’t calculate the size of this fund according to what money you bring home, but according to how big your critical expenses are.
So, take predictable monthly expenses such as your mortgage or rent, your food costs, any recurring healthcare costs, utilities and bills, transportation costs and debt obligations. Add those up, then multiply by six. That’s how much cash you should have on hand for emergencies.
This isn’t one of those “the bigger, the better” cases. An emergency fund must be immediately accessible, so you can’t tie this money up in investments. Therefore, there is a certain opportunity cost to every dollar that goes into this fund — every dollar set aside for emergencies is a dollar that you cannot invest.
That’s why the six-month rule is a good one to live by. Any less, and you risk not having enough to get through lean times. Any cash beyond six months of living expenses should go toward paying off debts, if you have any, or investment opportunities.
That said, there are certain circumstances in which you can be flexible with the size of your emergency fund:
If you have a good safety net of friends and family, and you only have your mouth to feed and carry no large debts, three months of expenses could be enough for you.
If you’re bringing home inconsistent pay (say you’re working as a freelancer, or you’re switching jobs and cities often), consider saving nine months of expenses in your fund.
Where Do I Find the Money for an Emergency Fund?
Saving money for emergencies is nearly impossible if you carry large debts or are undisciplined in your spending. So, if you haven’t done so already your first step is to pull together a smart budget so you can track your spending and make necessary changes.
Each month, set aside a little money from your income to put into your emergency fund, even if it’s just $20 in those first months. As you find ways to save more and more each month, you can then divert those savings into emergency funds and retirement accounts.
“Ideally, you should treat your emergency fund like any other recurring bill that you must pay each month,” Investopedia says. “Dedicate the appropriate amount from your paycheck and set it aside. While most people have no qualms about regularly sending enormous amounts of money to credit card companies, they balk at the idea of paying themselves first. Change that equation; cut up your credit cards and put those payments into your emergency fund.”
Where Should I Keep My Emergency Cash?
In an ideal world, you wouldn’t ever have to touch your emergency cash. But when you need that cash, you want to be able to get to it quickly and easily. Dave Ramsey recommends putting this money into a checking account, a savings account or a money market account.
Avoid the temptation to try to “make this money work for you,” i.e. invest it. Will you earn money month-to-month off of this fund? No. But realize that you are nonetheless investing in yourself by creating an emergency fund.
“Some of us feel safer with a pile of cash on hand for when life happens,” Ramsey says. “Others don’t want money to just sit there. They want to do something with it — like invest. Remember, though, the emergency fund is doing something. It’s giving you peace of mind. You sleep better at night when you have cash saved. That is a great investment return on your money!”
The bottom line: You don’t want to be among the 69 percent of Americans who aren’t able to afford a $1,000 home repair without having to borrow money. Start building your emergency fund as soon as possible, with as much as you can afford to save every month.
As with any form of insurance, you’re not going to need it until you need it. When that day inevitably arrives, you’ll be glad you took action in advance and began to save.
Casey Meehan is a writer and business owner who was born in Colorado, went to school in New Orleans and now lives in Chicago. He enjoys writing about everything under the sun — from investment tips at StockHax.com to writing music to entrepreneurship.