The Importance of an Emergency Fund
Everyone needs to prepare for the unexpected. Even in the modern world of insurances and assurances, the unfortunate – and the expensive – still happens. When other safety nets aren’t enough, an emergency fund is the last line of defense against major unforeseen expenses. As many as three quarters of Americans live paycheck to paycheck, but if you have the means and the motivation, you can build a rainy day fund to offer you protection and peace of mind.
Why You Need an Emergency Fund
The purpose of an emergency fund is to guard against unexpected financial emergencies such as loss of income or major expenses. These events can include job loss, medical bills, home or vehicle repairs, and more. An emergency fund doesn’t just absorb the immediate financial costs of such events, however. It also protects against secondary costs such as interest from borrowing, fees or tax penalties from withdrawing illiquid assets and other hardships or missed opportunities that might result from struggling to cope with unexpected financial difficulties. If you’re currently in a financial emergency, such as carrying high-interest debt or missing payments, resolving that situation takes priority. However, if your finances are sound, it’s likely a good time to begin building your fund.
How Much to Keep in Your Fund
The most important thing to get right about your fund is how much money to keep in it. This amount is usually expressed as a multiple of your monthly expenses. Keeping three to six months’ worth of expenses in your fund is generally recommended. Without knowing the future, it’s impossible to know the “perfect” balance for your account, but your personal situation can help you decide whether to favor a larger or smaller amount. Less income security, larger family (pets included), more property (such as homes and vehicles) and fewer safety nets (such as insurance and extended family) all generally indicate a need for a larger fund and vice versa.
Where to Keep Your Fund
Above all, your emergency fund’s balance should be safe and quickly accessible. That means keeping it away from risk such as the stock market and keeping it in a liquid form such as a bank account. An FDIC-insured checking account at a local bank or credit union generally provides the best protection and access to your money. If you’d prefer that your emergency fund earn a bit of interest, you can compare locally and nationally available rewards checking and high-interest savings accounts.
When to Use Your Fund
Any expense that’s necessary to your health or income earning that you can’t pay without incurring high-interest debt (e.g. credit cards) or dipping into long-term savings or investments would generally be considered an emergency. If such a situation arises, don’t be shy about using your fund. That’s what it’s there for! Just be sure to build it back up as soon as you’re able. Conversely, a “must-have” shopping deal or a “much needed” vacation are not emergencies. Don’t be tempted into raiding your fund for frivolous purchases, and make sure you’re budgeting separately for inevitable expenses like home and vehicle maintenance.