Have you ever had a sudden expense that you did not expect? The question is not if but when. The next question is, how can you pay for a sudden expense? That is the purpose of an emergency fund: to make sure you can focus on the problem at hand and not end up with a financial emergency on top of a life emergency.
So, what is an emergency fund and what isn’t an emergency fund? Why should you have an emergency fund? How big should it be? Where to keep your emergency fund? Read on to get answers to these and similar questions.
What is an emergency fund?
An emergency fund is ‘safe’ money set aside to pay large sudden expenses such as:
- Unforeseen medical expenses
- Death in the family (travel, burial fees, etc)
- Sick pet
- Major auto repair
- Leaky roof
- Plumbing issue
- Home appliance repair
- Unemployment – if you suddenly lose your job you can continue to pay monthly expenses
More later on what ‘safe’ money counts as.
What isn’t an emergency fund?
A checking account is NOT a good place to keep an emergency fund because it can more easily be spent, especially if it is tied to a debit card.
Other assets you may own and have equity in such as your car or home are not included. That is because of the time and hassle it would take to convert the asset into cash. Only ‘liquid’ assets that are readily available as cash count as an emergency fund (with some minor exceptions).
A credit card isn’t your emergency fund because:
- This is borrowed money – when you save your money in the bank, you give it your “future self”. On the other hand, when you borrow money on a card, you go into the red and you need to return the money you borrowed from the card using future income which may not be as easy as before.
- The interest rate is high – paying for an emergency with a credit card not only creates debt, but you will pay interest on that debt! Most credit cards charge double-digit interest rates, making it even harder to get past.
- A credit card may not be accepted – the bill may be so large it will not fit within your available credit. Some providers (funeral homes, plumbers, etc) will not accept credit cards and require a check.
How to build an emergency fund?
- Calculate the amount you want to save and budget for it – Wealth Meta has a calculator for that!
- Set a monthly savings goal – the easiest way to do this is to automatically transfer funds to the emergency savings amount as soon as you receive your paycheck.
- Keep the change – if you have left over coins or small bills, collect them in a jar and every so often take it to the bank and put it in your savings account.
- Save your tax refund – if you get a refund when you pay your taxes, you can redirect that money to your savings account for the emergency fund.
- Estimate and adjust contributions – if you’ve raised enough money for emergencies within six months or even raised twice as much, then you can open another savings account for vacations, debt reduction, or for having fun.
If you want to live without stress, to always have a calm mind, the best solution for unexpected expenses is an emergency fund.