What Is An Emergency Fund? Why Do You Need One and How Does it Work?

Posted October 11th, 2011 in Saving by Jeremy Waller

emergency fund

One of the major components of being financially fit is to have an emergency fund. Having a lump sum of cash in the bank will give you a financial peace of mind and set you apart from the majority of people who are living paycheck to paycheck.

The vast majority of people would be up a creek without a paddle if they lost their jobs tomorrow. Many wouldn’t even be able to make it to the end of the month.

An emergency fund is the solution to this huge problem. Along with following a budget and paying off debt, an emergency fund is one of the keys to taking control of your finances.

Why You Need An Emergency Fund

Picture this: You walk into work tomorrow and your boss calls you into his office. “Jeremy – The company has had a rough year and we’re being forced to downsize. I’m sorry, but your position will be eliminated at the end of this week.”

If you’re like most people, that would be absolutely devastating. How will I pay my bills? Will I be able to put food on the table?

An emergency fund is important. It gives you a buffer so that you have room to breathe if you lose your primary source of income.

An emergency fund is also beneficial when you have those large and unexpected expenses – things like if you have to replace your roof and your insurance company won’t cover it or medical bills (even with insurance, you may owe thousands out of pocket.)

How Much Should You Save For an Emergency Fund

Practically all financial advisers agree that you need money in the bank for emergencies. Though none agree on a specific amount you should have.

Dave Ramsey recommends 3 to 6 months of expenses. Suzie Orman believes you should have 8 months worth of expenses in the bank. (She refers to it as ‘Safe and Sound Money’).

I think 3 months is a little lean and 8 months may be a bit much. 6 months is a good mid point and it is what I am working to have in savings. The key question is how long would it take you to find another job. Take that amount of time and double it. With the economy the way it is right now, the job market is extremely unpredictable.

The industry you work in is also a big factor. Those with a limited field of expertise will need a bigger cushion than someone who is able to work in a wide range of fields.

The bottom line is this: your emergency fund should be large enough to carry you though any period of unemployment.

How To Save For An Emergency Fund

First thing’s first. You need to pay off all your debt (except for your mortgage) before you start packing away thousands of dollars into savings. It’s a great idea to do a mini-emergency fund of $1,000 first (a la Dave Ramsey). But after that, it’s all about paying off debt.

If you followed a structured plan to pay off your debt, then it shouldn’t be any problem at all to redirect that extra income towards a savings account.

Building up your savings will require as much if not more discipline than paying off debt. You need to contribute as much as you can month-after-month. It will take some time to save several months of expenses.

Seeing all of that money in the bank, it can be temping to slack off. But don’t do it! You have to be laser-focused just like you were when paying off debt.

Where to Keep Your Emergency Fund

An important thing to consider is where to actually keep your emergency fund. (Hint: the Bank of Mattress isn’t a great choice.)

You need an account where there is zero chance that you could lose the money. That means you don’t go and put this is an investment account. The prospect of earning 8% on the money may sound good, but what happens when you need to use the money and the market happens to be down 20% from when you put the money in?

Well then CDs may sound like a good idea. They’re safe and allow you to earn interest on your money. The problem is, they also lock your money up. Your emergency fund becomes illiquid which defeats the purpose of an emergency fund.

A great place for an emergency fund is a flexible high interest savings account or a money market account that is FDIC insured. Some credit unions are paying great rates on accounts. My checking account is currently earning 2.96%.

Stupid Emergency Fund Strategies

Okay, so I also want to talk about some stupid strategies I’ve heard from people. These are terrible ideas. I mean, really terrible.

One strategy I’ve heard some financial advisers offer is to use a RothIRA as your emergency fund. The reason they say this is a great idea is that you can withdraw your contributions (but not the earnings) without penalty.

There’s two problems with this. First, this violates one of the rules above – this money needs to be 100% safe. Even low-risk investments can decrease in value. Second, IRA contributions are limited to $5,000 per year total. So if you contribute $5,000 and withdraw $3,000 for an emergency, you can’t repay it. You already hit the $5,000 limit.

I’ve also seen people saying that you should just use your biggest asset as a lifeline – your home. They say if you need money for an emergency, just get a home equity line of credit. Well, what happens if you lose your job and there’s no equity in your house? What if the bank takes 60 days to approve the HELOC? What if they don’t approve the line at all?

And the absolute worst advice I’ve seen is to just use credit cards. Hello? Seriously?

One other no-no is combining your emergency fund and your play money. They say, don’t dwell on the negative. Save for something positive like a boat or a vacation. If trouble strikes, use the money for an emergency. If you never need it, then go to Hawaii!

Then, it’s inevitable that you would break your leg in Hawaii and come back to $5,000 in medical bills and be out of work for 6 weeks. Just use your emergency fund! What? You used it to go to Hawaii? Whoops…

Emergency Fund Calculator

To make all of this simpler, you can use an emergency fund calculator to get an idea of exactly how much you need for your emergency fund.

Bankrate has a calculator that covers most of the major items.

Do you have an emergency fund? If not is it something you are working towards?

Image credit: Senior Living

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6 Responses so far.

  1. Many companies also give you lump sum when you get laid off. Usually the number of years of service equals number of weeks of paycheck. 5 years of service = 5 weeks worth of paycheck. In my situation, I really do not need an emergency fund because of this benefit. You should check your company for more info on this.

    • Jeremy says:

      What if you’ve only been there one year? Is one week enough time to replace your lost income? What if you get fired or the company goes bankrupt? What if you get injured and can’t work for 12 weeks? A promise of severance pay if you’re laid off is no substitute for an emergency fund.

  2. Bill Swan says:

    There’s a savings ratio I ran into that makes sense. It’s called the 3:3:4 ratio.

    Stick to it and you will have not only enough to live off of, but also a little bit saved up and something to splurge on.

    The first aspect of this money management system is that there are prerequisite facts already taken care of. This means the utilities are paid, the food is bought and the rent is sent out. The ratio deals with the money left over after paying for the absolute necessary items. Here’s the explanation quoted from my site –

    The breakdown of the ratio goes like this: 30 percent of the available money goes to the bank; 30 percent of the spending money goes to an investment or savings; the remaining 40 percent goes to something fun for you, your family or the house.

    You must allow the 40 percent for fun to counter-balance the other 60 percent being put aside for later and/or emergencies. If there is no reward for doing a task, the task becomes a burden and the meaning is lost.

    • Jeremy says:

      That’s a good system. I’ve seen something similar for those trying to budget an irregular income where a baseline budget is set and extra income above that is allocated using a similar ratio.

  3. Kevin Stoner says:

    I think part of what needs to be considered is what is generally accepted for the emergency fund to cover. For some people, this might be emergencies such as a car break down or a water heater that stops working. For others, this might mean being totally unemployed with no income for up to a year. That’s why I struggle with how much of an emergency fund to have, because there are varying levels of emergencies… although I would say that more money is a better buffer, in general.

    • I like Dave Ramsey’s position on this. Start with a $1,000 emergency fund to cover things like a broken appliance. Then focus on paying off your debt. Once you are debt free, go back to your emergency fund and build it to where it can cover your living expenses for at least 6 months if you were to lose all of your income.

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