The Importance of an Emergency Fund

As we travel down the road to financial together on this blog, I’ll cover a lot of different financial topics. We’ll talk about investing, insurance, banking, purchasing a home, purchasing a vehicle, and so on and more importantly, we’ll talk about how to do these things in the most financially efficient way as possible. However, like many things, a person’s financial position is only as strong as its foundation. So today I want to talk about what many financial gurus consider the foundation of a person or family’s financial position. The topic today is “The Importance of an Emergency Fund.” You’ve probably heard this term before and hopefully you already have one set up, but because an emergency fund is so important, I think it would be doing the readers of SeekingFF a great disservice by not devoting at least one post to this topic. So, with that being said, let’s explore exactly what an emergency fund, why you need one, and how big of a fund you need.

What is an emergency fund?

First of all, what exactly is an emergency fund? Well, like its name suggests, it is a fund set aside for emergencies. Any financial situation that is unexpected or unplanned can be considered an emergency. Maybe your car breaks down, your furnace goes out, or maybe you laid or off or even lose you job. If you don’t have some money set aside for one of these emergencies, how do you come up with the money? A lot of people turn to credit cards, home equity loans or borrowing from friends. In a worst-case scenario, you simply can’t come up with the money needed and that can be a major problem. In any case, it is always better to have your own money set aside to deal with these emergencies.

How much do you need to have?

A typical response from a financial planner is 3 – 6 months worth of living expenses. Another common answer that I often see is $10,000. The amount really depends on the individual but again the most important part is having some money set aside.

Where to keep your emergency fund?

There are several popular options but the main thing is that it needs to be somewhere where you can access it quickly. That being said, under your mattress in $10’s and $20’s is not recommended! The best place in my opinion is a simple savings account. That way if an emergency comes up, you can quickly transfer the money to your checking account and pay for it.

Where not to keep your emergency fund

If you have large chuck of cash sitting idle in a savings account, you may be tempted to put that money in the stock market or a mutual fund to get a better rate of return. While it is true that you will probably get a better rate of return, the market is not the place to keep your emergency fund. What if the market is down when you need that money? Sure it will come back up sooner or later but you need the money now. Do you really want to take a loss or your hard earned money?

What about Certificate of Deposits? Yes CDs are safe and pay a little better interest rate but unless your emergency arises in the month your CD is maturing, they are not liquid. To get your cash out, you’d have to forfeit any interest it had earned since the last time it renewed and possibly even pay an early withdrawal penalty.

As I said earlier, the best place to keep your cash stash is in an easily accessible savings account. The good thing though is that this doesn’t mean your cash can’t earn money for you. You could put it into a safe, FDIC Insured Online Savings Account and earn a rate 8 – 10 times what a traditional brick and mortar bank pays on their savings account. For more information check out my Online Bank Accounts post.

Summary

Remember, your financial position is only as strong as its foundation and the foundation of any sound financial plan is an emergency fund. So if you don’t already have some money set aside, start saving today. It may take awhile to get 3 – 6 months worth of expenses saved, but eventually you will get there. And when that emergency comes up, you won’t have to worry about where the money is going to come from or how much extra you’re paying in finance fees to pay for this expense, you can just concentrate on the most important thing, getting the issue resolved.

{ 4 comments… add one }

  • Russ August 15, 2008 at 2:37 pm

    I agree that it’s smart to keep some money safe, liquid and easily accessible for emergencies and other unplanned needs. However, instead of parking it all in a savings account or money market, another option is to keep some of your emergency fund in a savings account and have quick access to additional funds via a home equity line of credit or similar vehicle. Of course, this can be dangerous for some people and lenders have gotten more discriminating with their willingness to setup these lines of credit.
    Great post.

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  • Chris August 15, 2008 at 5:17 pm

    @ Russ

    Good point. If you are a homeowner and have some equity in your home, a home equity line of credit can also be used as a portion of your emergency fund. Keep in mind though some of the risks associated with HELOCs though. If home values begin to fall like they are in the current credit crisis, you may find you have a lot less equity in your home than you did when you took out your HELOC. Your lender could even reduce your credit line if they think your home value & therefore home equity has fallen significantly. Keep these things in mind if you are using a a HELOC as part of your emergency fund.

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  • GaryJay (aka Old dude) August 16, 2008 at 3:12 pm

    Being my age (71), one just hopes there won’t be any emergencies, but again being 71, I’ve learned emergencies do happen, and yes be prepared. Don’t put all your funds in to those areas that take you forever to unwind and get your money back. Keep funds readily available to handle those small emergencies, (a new tire for the car, that need for a plumber—–the key is to have these funds readily available, yet in a place that they continue to earn some interest. I do not recommend keeping cash buried under the mattress—-, with my luck the house would burn down and how would I ever prove I had xxx amount of cash burned up??

    Gary (aka old dude)
    http://threescoreplusten.blogspot.com/

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  • Chris August 18, 2008 at 5:46 pm

    Old Dude:

    Yeah these things seem to come along at the worst times. All we can do is try to be prepared. An emergency fund gives you a nice cushion so that when an emergency comes along, you can focus on getting it resolved instead of worry about how to pay for it. Thanks for stopping by and sharing your experiences.

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