Planning Your Emergency Fund

by MB on January 20, 2008

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Introduction

The primary purpose of an emergency fund is to replace lost income should a member of your household lose a job.

Secondarily, you can use it for large, unexpected, expenses such as a car repair. An emergency fund allows you to face a traumatic event, knowing that you don’t have to take on debt. If you finance an emergency with debt, you are compounding your problems.

Keep your emergency fund in an account that you can access quickly, without early withdrawal penalties. A savings or money market account is ideal.

How much should you keep in your emergency fund?

When establishing your fund, a general rule of thumb is to keep 3 – 6 months of expenses. Expenses, in this case, would include mortgage and other loan payments, utilities, insurance, and groceries.

Here are some factors you should consider when determining whether you want to save more than the 3 month minimum:

  • How many “bread winners” do you have in your household? If only one person is responsible for most of your household income, you may want to increase your emergency fund.
  • How many people are in your household? If you are single, or have no children, you may feel safe with only 3 months of savings. If you have children, you need to think carefully about increasing your emergency fund.
  • Where do you earn your income? If you, or your spouse’s job is in a cyclical industry, you should increase your emergency savings

Saving your Emergency Fund

I would suggest defining the amount you want to save, divide that amount by the number of months you think it will take you to save, then have that amount automatically transfered from your paycheck into your emergency account.

If you don’t have enough room in your budget right now, start by saving a small amount, say 5% from each check, then increase the savings as your income increases.

Ideally you should strive to have a fully funded emergency account within 24 – 36 months.

When to use your Emergency Fund

Remember, the emergency fund is for large, unexpected expenses. Vacations, or a home remodeling project, are not emergencies. These are medium term savings goals, and should be saved for in a separate account.

If you are forced to use a portion of your emergency fund, you should immediately stop all other savings plans until you have replenished your account.

Emergency Funds and Debt

While I advocate everyone have an emergency fund sufficient to get them through tough financial times, I also think it is a very good idea to be completely free of consumer debt. By consumer debt, I am primarily referring to credit card debt, but also other non-mortgage debt such as automobile loans. It doesn’t make a lot of sense to build up an emergency fund, while sending money out the door every month in interest payments.

Consider saving a partial emergency fund ($2-$3 thousand), then pursue an aggressive debt reduction plan. If an emergency should occur during this time, you will have at least made room on your existing credit lines.

{ 1 comment… read it below or add one }

Debt Free Revolution January 21, 2008 at 12:47 pm

I would like to expand on the idea of ditching the consumer debt: If you don’t have any payments other than your mortgage and your utilities, then you don’t need nearly as large of an emergency fund! Or, if you still want a large one, it goes much much further when it becomes necessary ;)

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