Almost half of Americans can’t cover a $400 dollar emergency. That could be a broken house window, broken leg, car repair or a number of other things that can pop up instantaneously and can’t really be put off for very long. It would be nice if you could anticipate every event in life, but you can’t. Which is where an emergency fund comes in to play.
Building an emergency fund should be one of the first steps in your financial plan. Emergency funds are critical because they keep you from going into unplanned, unnecessary and high interest debt when surprise expenses inevitably will happen. Contributions to your emergency fund should be built into your budget so that your fund is constantly growing, and so that when you have to use money from the fund, it automatically starts replenishing itself.
How Much Emergency Fund?
A good starting target for your emergency fund is $1000 in cash. This should cover the deductible in most car and house insurance plans. It will cover a good chunk of the out of pocket portion for most emergency medical procedures. It will more than cover a surprisingly high utility bill. With $1000 as your goal, I would suggest putting close to $100 per month into your emergency fund, anticipating and emergency a month. However, the amount you need in your emergency fund partly depends on how you have budgeted for other categories.
It may work better for you to rely more on surpluses in all your other categories than on a single dedicated emergency fund. For example, you might typically spend $600/yr ($50/mo) on car repairs, but you budget $75 per month just to cover serious breakdowns. And an extra $20 a month into your utility bill should cover the occasional high bill. If you own a home, you should have a home maintenance fund to cover that broken window. And if you do have an expense that exceeds what you’ve stashed away in the appropriate category, it would now be a lot easier to borrow from another category than if all your categories are budgeted down to the wire. So the point isn’t necessarily how you earmark your emergency fund, but rather that you have a $1000 cash buffer somewhere.
Where Should I Park My Emergency Fund?
Note that I specified $1000 cash buffer. You need this money to be readily accessible. So don’t try and earn a little extra on it by investing it in a mutual fund where you’re exposing it to volatility. Keep it in a savings or checking account (or your underwear drawer), where you won’t be tempted to spend it on everyday purchases, but where you know it will be for when you have that emergency (a broken TV doesn’t count as an emergency).
A Double Layer Emergency Fund
This $1000 cash buffer also shouldn’t be your only emergency fund. You should also be working on a fund to cover your living expenses in case of job loss or some other form of income displacement. This second fund, however, is not quite the priority as the $1000 cash buffer and can be kept in somewhat conservative investments (perhaps a stock-bond blend). You should be working on building your $1000 on day one, even more aggressively than debt pay-off (although if you have 25% interest credit card debt, you should probably be equally aggressive on that). Once you have your $1000, you can start building up your larger fund. Don’t focus only on this second fund however. At this point, you’ll also be wanting to build things like a retirement fund or down payment fund. And if you have troublesome debt, definitely get rid of that before you work too hard on your second fund. In the event of income loss, bloated debt would eat up any money you stashed away in a hurry.
For some great tips on kickstarting your savings, Power Over Life has a great blog post on creating an actionable savings plan.
While I do strive to only write accurate information and dispense valuable advice, I am not a licensed financial adviser. All information is based solely on my personal experience and personal research and should be treated as such. Find out more.