You’ve probably heard that you should have an emergency fund. Maybe you even have one already. But would it actually help in an emergency? Not just a small emergency, but a serious one? The answer, for many people, is no. Depending on the size of your emergency fund, and various other factors, you may find your emergency fund is pretty useless. Here are a few things to keep in mind when creating an emergency fund.
Forget the $1000 rule
You may have heard that $1000 in the bank is an emergency fund, but how far would $1000 actually go, given your current lifestyle? The source cited is for this arbitrary figure is often finance guru, Dave Ramsey, author of The Total Money Makeover. People seem to forget that the $1000 emergency fund is the first of several ‘baby steps’ that Ramsey advises. $1000 is good. It’s great if you had $0 six months ago. But this is intended to be a ‘starter emergency fund’. It’s the very least you might need in a minor emergency. In fact, in a couple more baby steps, Ramsey will be advising you to create an emergency fund that will cover 3 to 6 months of expenses.
Be cautious with the ‘3–6 months of expenses’ rule
One problem with this is that it’s often quoted as 3–6 months of income, rather than 3–6 months of expenses. This is a healthy emergency fund, but you need to consider it in the wider context of all your finances. What if your income isn’t meeting your expenses and you’re already in debt? Then saving 3 or 6 months of income may not be sufficient.
Saving 3–6 months of expenses is a better way to look at things, but even that will only help in some emergencies. If you lose your job, and it’s highly likely you’ll be back in work within 6 months, your fund will cover you. If you’re injured, ill, or suffering from major mental health issues, it may not. And what if you lose your job and can’t find another one in your area? What if you have to relocate? Consider all your circumstances when trying to work out if you need 3, 6 or more months’ worth of expenses in your fund.
Don’t assume an emergency fund can replace insurance
This should go without saying, but your emergency fund should be on top of insurance. Only you can decide how much and what type of insurance you need. Apart from the obvious ones like health, car, and house, you may, at various points in your life, need life insurance, travel insurance, pet insurance, or even umbrella insurance.
Insurance is one of the few things we buy hoping we’ll never have to use it, but it’s well worth making sure we’re fully covered. Something as simple as an unexpected vet’s bill can wipe out that little ‘starter’ emergency fund overnight. Yet relatively few pet owners are insured. You can’t insure against everything, which is why you need an emergency fund. But you need insurance too. Assess the types of emergencies you’re vulnerable to and insure against them. Then start creating that emergency fund.
Ring-fence your emergency fund
Some people wonder what the point of an emergency fund is when they could just draw down on their regular savings if needed. However, consider the nature of emergencies for a moment. They are, by definition, sudden and unexpected. It’s important to keep your emergency fund somewhere you can get at it quickly. You don’t want to invest it anywhere that requires notice to access funds, and you don’t want it invested in the stock market, because emergencies don’t tend to wait until it’s a good time to sell.
You also don’t want to be tempted to blow your emergency fund on non-emergency spending, so it’s a really good idea to segregate it from other funds and savings.
Do I need an emergency fund if I’m paying off debt?
It’s almost always a good idea to prioritize paying off debt, especially if you have a lot of it. But here’s the problem. If you have an emergency, and no money to deal with it, you’re going to have to go straight into more debt to pay for it. And that’s if you can even get more credit, and access it immediately.
If you have no money at all, you’re probably going to put any emergency spending on a credit card (if you haven’t already maxed them out) which is, of course, the most expensive form of debt most of us have. That’s why Dave Ramsey advises building that $1000 emergency fund, even before paying off debt. Then you can at least deal with smaller emergencies, without the stress of finding someone who will loan you even more money, at short notice. And ultimately, that’s what an emergency fund is. It’s a way to avoid heaping more stress in an already stressful situation.
Disclaimer: The information in this article is not intended to encourage any lifestyle changes without careful consideration and consultation with a qualified professional. This article is for reference purposes only, is generic in nature, is not intended as individual advice and is not financial or legal advice.
Originally published on Wealthtender.com.