One of the most important components to any sound financial plan is having a good emergency fund. An emergency fund is simply an account that is used to set aside emergency savings earmarked for a rainy day. Rainy day funds should be easily accessible in the event of an emergency, but should not be used for any other discretionary spending.
Financial emergencies come in all shapes and sizes, but generally arise from a loss of income or a sudden, large expense. Examples include the following:
- A close relative dies and you need to fly internationally to attend the funeral
- You lose your job and remain unemployed for an extended period of time
- Unexpected medical expenses arise that are not covered by your health insurance
- Your roof starts leaking and needs replaced
Although this is subjective, I’m guessing emergency savings should not be used for things such as:
- The newest Ipad was just released and you don’t have it
- Your football team finally made the playoffs and you need to go
- You’ve always wanted to see Paris and airline tickets are 10% off
If you have adequate emergency savings, you can use these funds so that you don’t have to pawn your wedding ring, obtain on a payday loan,or rack up credit card debt which could exacerbate the predicament you are already in. You really can’t afford to not have a rainy day fund.
Where Should I Keep My Emergency Fund?
If you walk into a bank or other financial institution and ask to set up an emergency fund account, you will probably get a few raised eyebrows since there is no such product. It is up to each individual to choose and open an appropriate bank account to serve as the rainy day fund.
An emergency fund should be highly liquid and risk free since you need it to be safe and accessible at any time. You should also be earning a competitive rate of return on your emergency savings while it just sits there.
Open a newsavings or money market account for your emergency fund so that the funds are clearly separated from those you use on a regular basis. Keeping your emergency fund in your checking account that you use to pay your regular bills could be a recipe for failure.
How Much Emergency Savings Do I Need?
In a perfect world, you would save just enough to cover the emergencies that will arise. Why do I say that? I say that because I am a big proponent of keeping your assets working for you, and money in your emergency fund likely won’t be making you a whole lot of money. Historically, over long periods of time, money invested in riskier assets such as stocks has generally rewarded investors with higher returns than funds invested in ultra safe and liquid assets.
Having said that, this is not a perfect world and nobody knows when an emergency will arise or how much money we will need. Conventional wisdom suggests you should save 3 – 6 months worth of living expenses.
My answer is that “it depends.” It depends on a number of factors. It depends on what types of risks you are exposed to, how stable your job is, how many people you provide for, how well insured you are, what other assets and liabilities are on your personal balance sheet, and a number of other factors.
3 months of living expenses might be sufficient for a single individual with a very stable job and significant assets. However, 9 months might not be enough for a couple that works at the same company, have unstable jobs, a handful of children, no assets, and little other recourse.
When in doubt I suggest being extra conservative. After analyzing our own situation, my wife and I decided long ago that keeping 3 months of living expenses in our emergency fund was sufficient, and that is what we have stuck with. If our circumstances change some day, then we will adjust accordingly.
How Do I Start My Rainy Day Fund?
You probably won’t be able to save en entire rainy day fund overnight, but you can get started by saving something, anything, in a new high yield saving account or money market account. I say “new” since these funds should be separated from your other funds.
Start small if you need to. Even contributing $50 or $100 a month towards your rainy day fund is better than nothing. Making a budget will help you know how much you can save each month.
In order to build your emergency fund quicker, see if there are any expenses you can trim or additional ways you can earn more money. You can also sell belongings you no longer need on Amazon or use your tax refund to give your emergency savings a boost.
Figure out what you can save and make a plan to put money away every week or month until you have reached your emergency fund goal.
Set up an automatic deposit or transfer from your paycheck or checking account to your new rainy day fund savings account each month so that you won’t forget. You likely won’t even notice the money is gone.
Once you have set up your account and have developed your plan, stick to it. Don’t invade your rainy day fund for things that aren’t emergencies, however tempting it might be.
What are your thoughts on emergency funds? How big of an emergency fund do you keep? Leave a comment below!