What is an Emergency Fund?
If you’re serious about staying out of debt and saving for retirement, building an emergency fund is a crucial bridge between these two goals. An emergency fund is a reserve of money that you can draw upon in the case of unexpected expenses.
While you hope you’ll never need to use your emergency fund, you’ll be glad you have it if you do. Maybe your car breaks down. You could use your emergency fund to fix it. Do you need to put down a deposit on a new apartment? You might dip into your emergency fund. Do you have unexpected medical bills? You can use your emergency fund to pay them off (unless of course, you can pay them off with tax-free HSA money instead).
Why do I Need an Emergency Fund?
What were to happen if you were to lose your job tomorrow? Would you be able to make rent next month? What about the month after that? If you’ve got a mortgage would you be able to make your mortgage payment for a couple of months?
If you’re banking on unemployment benefits carrying you through you might be in for a rude awakening. Did you know that unemployment benefits top out at $450 per week? If you were previously earning $5000 per month while employed, you’d be drawing a mere $1800 per month on unemployment. Still think that’s going to cover your mortgage, car payments, food, energy bills, and all your other expenses?
And that’s if you qualify for unemployment insurance at all. If you’re self-employed, a freelancer, or if you left work voluntarily or were fired for violating an employment policy, you likely won’t even qualify for unemployment insurance.
You need an emergency fund to make sure that if you hit hard times, you don’t unexpectedly lose your house or your apartment as you struggle to recover. An emergency fund can be a crucial lifeline to help you wade out the storm and to make sure that you don’t get buried in debt in the process.
How Much do I Need?
A general rule of thumb is that you’ll need 3-6 months of living expenses saved up for your emergency fund.
If this sounds overwhelming don’t fret. My personal opinion is that 3 months of living expenses is often adequate if your plan is to begin saving for retirement immediately after completing this step. My reasoning for this is that even if you did deplete your 3-month emergency reserve you likely could pull out some additional funds from your investment accounts if needed.
Even if saving 3 months of living expenses sounds hard, what you have to realize is that in an emergency, you’re not going to be spending as much as you usually do. Determine what your budget would need to be to get by in an emergency for 3 months. You don’t need to save up 3 months’ worth of discretionary spending if your plan is to tighten your belt during this time. You don’t need to save up enough money to go out to eat every week, you just need to make sure that you can pay your bills for 3 months.
Where Should I Store it?
Because your emergency fund needs to be accessible you have to be careful with how you store it. Sure, you could keep it all in cash under your mattress, but that’s not going to do you much good if your house burns down or somebody breaks in and steals it.
So what are your options? Well, you don’t want to invest the money in the stock market because the value of the money could fluctuate. If the market crashed, your emergency fund would be worth much less than it used to be.
You also don’t want to stick the money in a bond or long term-cd because your money is now locked up and unavailable to withdraw in the case of emergency.
The best option for storing your emergency fund is either to place it in a high-yield savings account or else to place part of it in a high-yield savings account, with the rest going into a short-term CD. For example, Schwab allows you to purchase CDs with a term of only one month. So if you had 1 month of savings placed in a savings account, it would likely be safe to place the other two months’ worth of savings in a cd with a 1-month term. This could potentially net you higher interest rates off your emergency fund while still offering you FDIC-insured protection, and most of the same flexibility.
Do I Need to Replenish it?
Every time you pull money out of your emergency fund, you need to replace that money as soon as you are able. If you pull a chunk of money out to finance a car repair, you would be wise to pause a portion of your retirement savings to allow you to reallocate that money to rebuild your emergency fund.
An emergency fund is something that you’ll want to maintain throughout your life. It will give you the peace of mind to know that you’ll be able to weather most storms should you fall on hard times. Once your emergency fund is built, it’s time to move on to step 3. Saving for retirement
As always, this information is a reflection of my own personal opinion and in no way represents legal or financial advice.