Why You Need to Start Building an Emergency Fund Now

I write a lot about the emergency fund (i.e. rainy day fund) on PT Money.

It just occurred to me that I hadn't actually written a post on starting one. I did detail how we put our savings in a high-interest savings account.

However, that post could easily be titled “open up your emergency fund in a high-interest savings account”, because besides our property tax savings, those “savings” are essentially an emergency fund.

But strictly speaking emergency funds, you could use a number of methods and types of accounts to hold your emergency savings in so I'll discuss those here. I'd also like to cover other aspects of emergency funds, like why you might want to have one and what key elements make up a good one.

What is an Emergency Fund

Wow, I said “emergency” a lot in that first paragraph. Sorry about that. Truth be told, I'll likely say it often in the rest of this post so just bear with me.

OK, let me first start with this: I knew nothing of emergency funds until I started listening to Dave Ramsey's radio show. I mean, I knew about having savings, but I didn't know to call it an emergency fund. So, thanks Dave!

I think calling your short-term savings account an emergency fund is a good way to motivate you to have one, because it gives you a clearly defined goal for that money. It also motivates you to have a nice-sized one.

My definition: An emergency fund is money that you set a side (a few months of your expenses) to be used only in an emergency. It's like a fire extinguisher for your personal finances.

The fund is typically made up of three to six months of your expenses and is typically held in a place separate from your normal spending account.

Why You Need an Emergency Fund

A good place to start this discussion is to decide why you might need one of these funds. The reasons basically break down into two main categories:

  1. you could have an unexpected loss of income (i.e. lose your job, get hurt or pregnant and can't go to work for a while) OR
  2. you could have an unexpected expense (i.e. your car breaks down).

Since most people aren't insured against every type of event that could happen, an emergency fund ends up being an excellent choice for just about everybody. Do you have one?

Key Elements of a Good Emergency Fund

Big Enough – Your fund should be big enough to help you through those events I just mentioned above. For example, if it would take you one to three months to find another job if you were to lose your current one, then plan on at least having an emergency fund of three or four months of your expenses.

What expenses? Plan on spending the bare minimum during your down time (i.e. cut the cable, don't dine out as much, etc.). I'm pretty conservative (I think) and aim to keep about 10K in a fund. That would keep me going well above the bare minimum expenses until the three or four month mark.

Accessible, but Not Too Accessible– The fund should be kept somewhere where you can get to it in your time of emergency. But I tend to think it should be kept far enough away so that you can't spend it on day-to-day spending. This means, don't keep it in your safe, regular checking account, or the savings account attached to that checking account.

On the flip side don't use a CD to hold your emergency savings either. CDs mature on a monthly basis at the earliest and so if you needed it right away, I'd expect that you'd pay a penalty for withdrawing your money early. Of course, you could use several CDs and have them in a revolving maturity schedule. That way part of your money would become available every month.

That's still not flexible enough for me though. I like the middle ground of the high-interest savings accounts: it usually takes only a couple of days to get your money from them. Perfect for most emergency situations.

Making Money for You – Lastly, as a bonus, you'd like your emergency fund to be earning money for you and keeping up with inflation. There are many online savings accounts that are FDIC insured where you can earn a few percentage points of interest on your money. That can add up quick.

The account I use is the 360 Savings Account from Capital One 360. I highly recommend it for it's user friendly interface, ability to create multiple savings accounts, and assess to variety of related products (i.e. checking, CDs, brokerage). To see this account compared with several other options, visit my high-yield online savings accounts page.

Is Your Emergency Fund is Big Enough?

The first thing I'd say is, if you have to ask, odds are it isn't big enough. 😉 I know I'm not going to get away with that easy answer though. So what I will do is try and give you some points to think about to give you confidence in your emergency funds. After all, I'm not going to be there to bail you out.

Know the Rule of Thumb

Most money experts will tell you that you need anywhere from 3 to 6 months worth of expenses in liquid savings (i.e. cash).  If you're unsure of how to calculate that number, or if you did calculate it and it didn't give you warm and fuzzy feelings, keep reading.

The reason the 3-6 rule is used is that for the typical family that's enough to help you get by for a bit if you lose your job. It also ends up being enough to help you cover unexpected medical bills, car repairs, etc. for the insured.

If you want more on this specific topic, here's our article about how much cash you should keep on hand.

Know Your Monthly Expenses

If you're going to use the 3-6 months expenses rule, you'll need to determine what that is. The quickest way to do that is to get online and view the last 6 months of data from your bank. Use that data to determine the total average monthly spending over the last 6 months. Multiply that average by 3, 4, 5, and 6 months. The other factors listed below are going to help you determine which of these numbers (3x, 4x, 5x, or 6x) to use as a basis for your emergency fund.

Know Your Insurance Deductibles

A job loss isn't the only type of emergency you could experience. Something could happen to your car, your house, or the health of someone in your family. Do you know how much your insurance company is going to cover? Are there large deductibles on your plans? Someone with a $5,000 deductible and a catastrophic health insurance plan is going to need a bigger emergency fund than someone with a premium plan who's deductible is in the $100s. Based on what you find out here, you may be in need of a 6-months e-fund vs the 3-month variety.

Know Where You're Not Insured

If you actually go without insurance for some area of your life, consider what an emergency in that area would cost you. Bump your emergency fund up based on what you have uninsured. Those without health insurance should really have a huge emergency fund to help cover those unexpected medical bills.

Know Your Assets

If you're a one car family, unless you live in the city, you are highly dependent on that car (asset). If that car needed a $2,500 repair, you'd have no choice but to spend the money to repair it. Likewise with your home. If your home is old and in need of constant repair, your emergency fund will need to trend higher to be able to cover those repairs.

Know Your Job Market

Are you the sole bread-winner in the family? How confident are you that you could get another job a few weeks or months after you've been laid off? If you think it would take more than a few months, because (a) your industry is in bad shape, or (b) you aren't that marketable (for whatever reason), then consider bumping your e-fund number up above the 6-month mark. Keep going until you feel comfortable with the number.

So where does that put your emergency fund? I think if you start with the 3-month rule and then bump that up based on the risk involved in the other areas I listed you can get pretty close to your actual required emergency fund.

When in doubt, just strive to make your emergency fund big enough to cover you for 6 months of income instead of expenses. That's a very conservative number and would put you way ahead of most other savers.

If you've decided that your emergency fund could use a boost, don't stop now. Take the next step and start saving more today.

How to Know If Your Emergency Fund is Too Big

Let's take a quick look at emergency funds and examine how much is too much when it comes to cash savings.

As a disclaimer, everyone should look at their own unique situation and decide how much short-term emergency savings is necessary.  For some, it may be $1,000, for others, $75,000. To get the conversation started I've come up with a list of reasons your emergency fund might just be too big:

1. It's More than 6 Month's Worth of Expenses

Most by now have heard this basic rule of thumb. Somewhere between 3 and 6 month's worth of expenses is what you should probably aim for when saving cash for emergencies. So I ask you, if you have more than this, why? Why isn't that money in an asset that will appreciate more for you, like real estate or other investments?

There may be some legitimate reasons though: You may have a history of illness in your family, or you may work in a specialized field with unemployment that is trending higher. If that's your situation then the rule of thumb above may not apply. Save an amount in cash that will provide you the confidence you can make it through an illness or major career change. But also consider that most non-liquid assets could be transferred into liquid assets within six months, so more than that may never be a good idea.

2. It's Not Insured

“The Federal Deposit Insurance Corporation (FDIC) preserves and promotes public confidence in the U.S. financial system by insuring deposits in banks and thrift institutions for at least $100,00.” If you've got more than $100k in the bank (1) you are awesome, (2) the amount over $100k may not be insured. If you're keeping this much cash because you think it's safer, think again. You might as well have it in stocks with the potential to earn more.

I have a friend in the banking industry and he shared that you can have more than $100k insured by having multiple accounts in different family member's names. So, if you're dead set on keeping it in cash, then just make sure you know the rules and you're protected.

3. You have High-Interest Debt

Your emergency fund may be too big if you have high-interest debt, like credit cards or auto loans. Earning 3% on your cash savings isn't doing you any good if you are paying 17% interest on consumer debt.  Get rid of that debt and then begin building up an emergency fund. Check out my post Credit Card Balance: Make Payments or Pay in Full? for more detailed information about the balance of savings and debt.

4. You have No Retirement Savings

You have $75k cash in the bank but you haven't been contributing to your company's 401k or an IRA then you're emergency fund is too big. Your 401k (or 403b or IRA) is a great tool for securing your retirement AND deferring your taxes. On top of that, its most likely comes with a matching contribution. If so, then if you aren't contributing to it then you are essentially telling your employer you don't want all of your salary. Trade the cash in for some long-term security and get your match.

5. You have No Home Equity

Building up at least 20% equity in your home ASAP is a great idea.  Getting to 20% will allow you to avoid private mortgage insurance (PMI) and will usually allow you to escrow your own property taxesand insurance.  Plus, it shows financial responsibility and commitment to your debt.  Take your cash savings and pay down that mortgage till you're at the 20% level, then begin building cash savings.

In the name of full disclosure, here's our current allocation between home equity, retirement savings, and cash:

Asset Allocation

According to my stats on the Millionaire in the Making series, the average in cash savings is $38,569.76, while retirement and home equity averages are $180,434.75 and $210,635.42, respectively.

In my opinion, we should probably shoot to have a larger percentage in retirement money even though we line up with the future millionaires. What are your thoughts on our allocation?

6. You Have One. Period.

Wait…what? That's right, some believe you shouldn't have much money in cash at all. Check out Lazy Man and Money who explains “Why I don’t have an Emergency Fund.” Lazy Man uses his HELOC as his emergency fund. I think if you look at the math of Lazy Man's suggestion it's a sound idea. However, for me, my heart tells me to have some “cash in the bank” for my rainy days. Another post on this method is Quest for Four Pillar's Reasons Why Your HELOC Can Be Your Emergency Fund.

Final Thoughts

Keep those elements and your main goals in mind and you should have no trouble setting up the appropriate emergency fund. Good luck.

Comments

  1. Release of Liability says:

    Life is full of unexpected surprises. You don’t want to wait until last minutes to build your emergency fund. A famous Buddhist once said, when you take off your shoes today, you don’t even know if you would ever have a chance to wear them again. Cherish the moment and always prepare for the worst.

  2. Investment Hunting says:

    An emergency fund is a must. If you look at like an insurance plan it makes sense. People typically buy term to protect their family if they die. So I view an emergency fund in the same way. I’m protecting my family for a short period of time where my ability to earn money is dead.

  3. MrFireStation says:

    We’re just FOUR weeks from early retirement (@ 49 yrs old) and so the concept of Emergency Fund has taken on new meaning for us. We’ve always held 6 months expenses in a money market or CD. Typically in a CD without an early withdrawal penalty through our credit union. We have expanded that to 36 months expenses as we approach our escape from corporate life. This way, when the financial markets start to rock, we are protected from having to sell anything.

  4. You could use no penalty CD’s and also rotate / ladder them.

  5. Thanks for the kind remarks, Joshua. I appreciate you swinging by and for the click love.

  6. Joshua from Debt Aim says:

    This is a fantastic breakdown of an emergency fund… i like the fact that u mention accessible but not too accessible… I will probably be checking into ING… i will use your affiliate link if i do.

  7. Gotta love the E-fund. Always good to start somewhere… Nicely laid out…