Emergency Fund Basics

by Kevin on February 8, 2009

(Photo by rightee)

Two days ago I showed you how your emergency fund may be larger than you think it is. Sometimes in articles I assume everyone knows what we are talking about. In this case, I want to make sure everyone understands the basics of emergency funds.

You need an emergency fund. It’s pretty simple. Here are my guidelines for this.

Emergency Fund Basics

Before we get started we need to get on the same page as to what an emergency fund really is, what it is used for, and why you should have one.

What do I use an emergency fund for?

Simply put an emergency fund is savings you have set aside specifically for emergency situations. Everyone will define emergencies different, but think of things like car accidents, medical bills, and job loss. (A deep aching need for a plasma TV is not an emergency.)

How should I set my emergency fund up?

The short answer: any way that works for you.

The long answer: Some people set up separate savings accounts for each of their savings goals. One account for the emergency fund, one for the car we are going to pay cash for, and one for that next vacation. Some people like myself pile all of the money into one account and separate it out on a spreadsheet. It doesn’t really matter how you separate it, as long as you continue to build up savings.

At the bare minimum you need 3 months worth of living expenses saved up. In this economy I would highly encourage you to push that to 6 months as it is taking much longer to find a job for many people. Living expenses are the costs that you simply cannot cut out of your budget like rent, power, and food. Eating out costs should not be equated in your emergency fund unless you are such a wimp that you can’t stop yourself from eating out when you are out of a job.

Your emergency fund should be kept as liquid as possible for your situation. I prefer to keep ours at ING Direct. For most people just dropping the emergency fund into a high yield savings account (currently paying around 2% interest) will suffice. I have attempted to put ours into a 6 month CD ladder, but the recent drop in rates has killed that idea. We have enough other savings (future car, trips, etc.) that if we ran into an emergency we could wait for the CDs to mature to provide us with that income. In a worst-case scenario we could withdraw the money early and pay the early withdrawal fee.

Why you need an emergency fund

It’s pretty simple — life happens. You cannot plan for every single thing that will test your finances over time. (If you know how to do this, please call me so I can post it up and instantenously become rich.)

Life happens. Hmph. Not a pretty answer. But it is true. I can’t tell you what will happen today or tomorrow or the day after. I may be involved in a serious accident. I may earn a promotion. I may need to relocate.

An emergency fund provides you with that required cushion to get you through tough times. I think we can all relate to that.

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Start-Up February 9, 2009 at 2:40 pm

You definitely nailed it when saying that emergency funds are different for every individual. Some people are more secure in their work, which doesn’t require as much saving for job loss. At the same time, everybody has different deductibles for auto and health insurance. Everybody is different when it comes to emergency funds. In everybody’s case though, they are important to have.

Ken February 9, 2009 at 8:18 pm

Emergency Fund…step 1 to any successful financial plan. I use an ING account for mine. Having it hard to get to makes me behave better.

Kevin February 16, 2009 at 9:29 am

@Start-Up: The only thing with being confident in your job is that it can be poorly placed confidence. In reality many folks have little power over what happens at their job.

@Ken: We use ING for ours as well.

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