Money Monday: Why You Need an Emergency Fund
Image from Freeimages.co.ukEven the best-laid plans have a way of going awry from time to time. You oversleep on the morning of an important meeting. Your friends show up for dinner a half-hour early, before you’ve changed out of your yoga clothes. (Can you tell I’m speaking from experience on that one?) Or maybe you’ve been diligently paying down your credit-card debt only to get socked with a big car-repair bill just as your net worth was about to climb into the black.
Try as we might, it’s impossible to troubleshoot every possible unwelcome development that comes our way. Alarm-clock snooze buttons will entice and friends will be early birds. But building an emergency fund can help ensure that unforeseen car repairs, medical bills, or even job loss don’t derail your financial future.
Conventional financial planning wisdom holds that you should stash three to six months’ worth of living expenses in your emergency fund, and that’s certainly a worthwhile goal. Higher earners will want to save even more, because it can take more time to replace a high-paying job than a lower-paying career.
Realistically, though, building an emergency fund of that size is a tall order when you’re just starting out in your career, particularly if you’re juggling other financial priorities such as paying down debt and/or saving for other goals such as a down payment on a house.
So how can you put in place an emergency fund that’s realistic and will also help cushion your personal balance sheet against unforeseen expenses? And if you haven’t created an emergency fund, where should you turn in a financial pinch? (Hint: Credit cards should be a last resort, ranking just in front of a trip to the payday loan store.)
Here are some emergency-fund pointers.
1) Get real about expenses.
Does the prospect of saving three to six months’ worth of living expenses seem laughably unrealistic? If so, step back and think how much you could get by on in a pinch rather than what you’re spending currently. Tote up your current monthly outlay for the bare necessities--rent or mortgage, food, utility bills, and student loan or car payments—then multiply by three. That’s your target emergency-fund amount, and chances are it’s a lot more manageable than the figure that flashed through your head when I said that you need to save three to six months’ worth of living expenses.
2) Take stock of your flexibility.
If you’re flexible about your lifestyle, you still need an emergency fund, but it may not need to be as large as if you have more fixed expenses. Maybe you currently live alone in an apartment, for example, but would be willing to get a roommate or move back in with your parents if you really needed to. If, on the other hand, you have a lot of non-negotiable fixed expenses such as a mortgage, it’s better to err on the side of caution and save a full three months’ worth of living expenses, or even more if you can swing it.
3) Know where to put your money.
Your emergency fund is to cover unexpected expenses, so you need to be able to tap it at any time. For that reason, it’s a mistake to keep your money in anything that could fluctuate in value, such as stocks or even bonds. Appropriate investments for your emergency fund are checking or savings accounts, CDs, money market accounts, or money market mutual funds.
4) Consider it sacrosanct.
Maybe your girlfriends are talking about a summer holiday in Greece, or you’ve been dying to take an expensive pottery class. When exciting opportunities beckon, it can be very tempting to raid your emergency fund and promise to replenish it later on. I have one piece of advice: Don't. Your emergency fund is there to cover true emergencies rather than expenses in the "nice to have" column.
5) Don’t go overboard.
Building an emergency fund is one of the best things you can do for your financial health, and having a stash of cash can provide a lot of peace of mind, too. But be careful not to put too much into your emergency fund. If you’re young, especially, you’ll pay a significant opportunity cost by stashing too much in the kind of low-returning/low-risk investments that should populate an emergency fund. Once you’ve saved enough to cover three to six months’ worth of living expenses, any additional assets you have to invest should be deployed in investments with higher return potential, such as stocks.
6) Multi-task via a Roth IRA.
It's ideal to cordon off your emergency fund from any other money you have set aside for other life goals, such as retirement. That way you can keep your emergency-fund money in safe investments, while steering your retirement savings to higher-returning investments like stocks. But building separate pools of money may not be realistic for many people, particularly for those who are just getting started in saving and investing. One way to multi-task is to begin saving in a Roth IRA, where you can withdraw your contributions at any time and for any reason without taxes or penalty.
7) Know where to turn if you don’t have one.
So maybe you've gotten religion about the importance of building an emergency fund. But what should you do if an unexpected emergency expense arises and you don't have the money? The good old Bank of Mom and Dad may be an option for some of you. But if it's not, withdrawing your contributions from a Roth IRA or taking a loan from your 401(k) is apt to be preferable to using more expensive forms of financing, like credit cards. A good rule of thumb is that the easier it is for you to get your mitts on the money, the more expensive that form of financing is apt to be.
Your Money Monday task for this week: Total up your fixed (i.e., can't live without/would go to jail if you don't pay) expenses for each month, then multiply by three. That's the minimum target for your emergency fund. If you've already begun building an emergency fund, compare what you've saved with your target. If you haven't started an emergency fund, set a realistic savings target for each month.
How have you been building an emergency fund? Share your saving tips in the comments!
Guest post by Christine Benz, director of personal finance at Morningstar and author of 30-Minute Money Solutions: A Step-By-Step Guide to Managing Your Finances (Wiley, 2010).
Enter to win a signed copy of 30-Minute Money Solutions by Christine Benz today! It’s easy – just post a comment following today’s Money Monday post and you’re entered to win!
Leslie Banks
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Love the Money Monday task! I live and die by my budget and offer my template to anyone who wants it. I have several "fund" catagories to my budget, I have listed 3 below that make it worthwhile and keeps me motivated to stay on track. 1. Trip fund, because having to say no to a girls trip reallys stinks (5% of monthly take home salary). 2. Contingency fund, this has saved my credit cards from being racked up many times (5% of monthly take home salary). 3. Entertainment fund, this gets spent every month on something fun (5% of monthly take home salary).
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