The Art of the Emergency Fund, where to put it in your Finances
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“Good planning and hard work lead to prosperity, but hasty shortcuts lead to poverty” Proverbs 21:5
So many times in personal finance, experts tell their followers exactly what to do, how and when to do it. The problem with that is lack of ownership. A steward is someone who takes responsibility and ownership for what has been given to them. The title of this post is to keep in mind that finance is not always an exact science. Each person and family will have different experiences, preferences and interests, along with setbacks and temptations. There is an art to finance, and the emergency fund is no different.
In the world of personal finance, next to having an income, an emergency fund is the most important part of a person’s or family’s financial foundation. I say this because, any budgeting, saving, investing or planning would be for not if an unplanned event occurred that wiped out any savings, retirement, or investing you may have started. An emergency fund is the life preserver or fire extinguisher of your financial tools, you hope you do not have to use it, but you are glad it is there when you do.
What makes an emergency fund unique is that it is liquid money that is set aside for no purpose except to provide a cushion for unforeseen expenses. Liquid meaning it is easy to get to and use, usually within no more than a couple days. This means that it does not have to be cleared, or assets do not need to be sold, which takes time. Unforeseen expenses meaning, emergency room trips, furnace breaks down, the car needs a new transmission, or you need a new car sooner than expected. An emergency fund is not an account you take money from for other purchases found in your normal budget, or you depend on in your overall financial picture.
I can hear the wheels turning. “This sounds easy Ben, put a bunch of money in a checking or savings account and call it good”. Not so fast. The questions of how much and where need to be carefully considered.
You will hear many people say you need 3- 6 months of either income or expenses in your emergency fund. Why not more? The reason is because of liquidity and opportunity cost. As your funds are more liquid, say cash under your mattress, a checking or savings account, you lose the ability to earn money from interest or investments. CD’s, mutual funds, stocks and bonds are less liquid, but yield a higher return. Opportunity cost is simply the next best thing you could do with the money you are using for something else. In this case, if your money is sitting in a checking account gaining 0% interest, it could be in a stock portfolio or IRA earning a higher return. So the problem is having enough money to cover expenses in a liquid account, but not too much, that the excess could be better used somewhere else.
This is where you come in. You will need to determine how much you want in your emergency fund. I recommend about 3 months of living expenses. That means bills, mortgage, food, transportation and everything else. If you hit hard times, such as being laid off, you will see your emergency fund last longer than 3 months as you will not continue your normal spending habits. I have found that anything beyond 3 months expenses would put you in the area of needing to get a loan, or something where payment plans would be an option. At least with 3 months of expenses, it is not going to derail any other savings plans. Again, keep in mind the main reason for the emergency fund is to prevent the depletion of your other accounts.
Now that you have made a decision on how much your emergency fund should have, the next step is deciding where to put it. Liquid options include cash, checking account, savings account, a CD or even a mutual fund (the last two being the least liquid). There really is not a wrong answer, find what is comfortable and what works best for you. But I like to think outside the box a little bit. I use a combination of a few of those accounts. I have about a 2 weeks worth of expenses in cash at my house in a safe place. I have about 1 months worth of expenses in a checking account, and I have the remaining in a mutual fund.
Here is my explanation for that. Anything really urgent I will use cash, if my check card will not work. If it is more than that and needs to be paid in full, I will use the cash and the checking account. If the emergency is even larger, I will use my cash, checking account, and a credit card while I wait for my mutual fund to liquidate the shares and put the money in my checking account, at most this takes 5 business days. I do this to take advantage of the liquidity, but also some of the investment I earn with the mutual fund.
I do not recommend taking what I said about a credit card, and using only that as your emergency fund, with your justification being you have a maximum credit of about 3 months of expenses, or more. I say this because it completely contradicts the purpose of an emergency fund, which is to not let sudden, unexpected emergencies cripple you or set your financial plan back. An unpaid credit card balance is the fastest way to do that. Don’t get me wrong, a credit card has its place. It is like any other tool, if used properly it can be very effective and beneficial (think about reward points, read my hubs about credit cards). But if it is misused, it is deadly. I would use a credit card with the intention of paying the balance off that month, paying nothing in interest.
Now that you know how much and where to put your emergency funds, the last step is getting your fund to its proper amount. Many of us would not be able to completely fund this account without sacrifice in other ways. We will need to build this up over months or maybe a year. My advice: Do this first before any investing, over payments towards debt, or any other savings. It may seem like taking a step back, but it will help you continue to move forward for years to come. Put all of your extra income and money towards this fund until it is at a healthy level. The great thing is once it is fully funded, you can redirect your efforts somewhere else, and sleep better knowing pretty much any unexpected expense will be taken care of without jeopardizing other plans and goals.
Tips Tricks Dos and Don’ts
- As your income and expenses grow, adjust your emergency fund accordingly. Revisit the amount at least annually.
- Do not place your funds in a place that charges you a service fee.
- Keep your attitude positive as you make sacrifices to build your emergency fund.