Many people are familiar with Murphy’s Law: “Anything that can go wrong will go wrong.” This adage can also hold true for finances. According to the 2012 National Financial Capability Study by FINRA, almost 40% of Americans could not come up with $2,000 if an unexpected need arose! What was also shocking is that 60% of Americans did not have three months of emergency funds to access if they were out of a job. This means the majority of U.S. Households do have a buffer to survive if there were big emergencies. To compound things 40% also said they have too much debt. This lack of cushion helps explain why when a recession hits, we see many bankruptcies and foreclosures as we saw in The Great Recession. Losing a job means being unable to pay the bills, and with no emergency fund and too much debt, it can only lead to financial instability. Because unexpected things occur in life, having an emergency fund is crucial as part of your financial strategy.
- What is an emergency fund? An emergency fund is money that is easily accessible for emergencies. An emergency fund is not used for investments, recreational purchases or even savings. It is used strictly for financial emergencies that require funds immediately.
- Why have an emergency fund? A sudden job loss, unanticipated medical expenses, or unforeseen auto and home repairs can be quite costly. If there aren’t enough funds to cover those expenses, relying on credit cards, loans or even pawning valuables can compound the problem.
- How much should I keep in an emergency fund? The general rule of thumb is to save between three and six months’ worth of your living expenses. This number can change based upon your personal situation. It can depend on family needs, how much debt you have and cost of living in your area. Three to six months’ worth of income is recommended since one of the most common reasons to use the fund is a sudden loss of income. It may take a few months to find a new job and the fund will be able to help you through the transition. Whether it be income replacement or major unplanned expenses, it is best to plan for a worst-case scenario.
- How do I start? Unless you already have a significant amount of money in savings that you can designate as your emergency fund immediately, it is best to start small. Accumulating it will take time and discipline, especially if it is three to six months’ worth of expenses. It is important to allocate a portion of your income and treat it like a bill that you have to pay every month. By budgeting for an emergency fund, you can be proactive to put money away consistently.
- Where should I keep the emergency fund? Because an emergency fund has to be liquid, it is best to keep it in a money market, savings or bank account. Make sure to find an account with a reasonable interest rate that is completely safe. You don’t want to have this money tied to the stock market since you can lose money over the short term.
One strategy is to diversify a portion of the fund into CDs that pay a higher interest rate, but it may not be immediately accessible. Don’t put yourself in a situation, however, of having the bulk of your assets in an emergency fund. You want to get higher returns by diversifying into stock market and other alternative investments while keeping an adequate amount in the emergency fund.