Benefits of an Emergency Fund
It might be 6 months from now, a few weeks from now, or even a few years from now, but at some point in the future, you will have some kind of financial emergency that will require a significant amount of money.
If you have an emergency fund in place, that financial crisis will be easier to handle.
Setting up a fund to handle adulthood’s unforeseen events is a mark of maturity and can be extremely beneficial to you.
Understanding the Meaning of the Emergency Fund
In its simplest terms, an emergency fund is a bit of money that you have easy access to and the money is designated only for a true emergency.
The funds can be in a specific savings account separate from your other accounts, it could be in a money market account or it could be a threshold amount in your checking account.
The two most important aspects are that (1) you can easily get to the money when you need it and (2) YOU ONLY TOUCH IT IF THERE IS A REAL EMERGENCY.
What do Most Experts Consider to be an Emergency?
Financial experts tell anyone who will listen that an emergency is something you did not see coming.
For example, a big storm blows through your neighborhood and does considerable damage to your roof. Your insurance company will take care of most of the expenses, but they expect you to pay $200 or $500 as a deductible. That is an emergency.
Getting the roof inspected and a few shingles repaired because the roof is 5 years old is not an emergency. That is simply part of owning a home.
Another example would be a car accident in which your car suffers some major damage, and you have to spend a couple of days in the hospital.
The repair shop expects you to pay the $100 charge to tow your vehicle to the garage and the hospital expects a $250 co-pay from you for the overnight stay. That is an emergency that you did not anticipate.
That is much different from your vehicle needing a new set of tires because your current set has over 60,000 miles on them.
People should not use emergency fund money to go on a vacation or buy a new outfit or update to the latest tablet.
And emergency funds should not be used to purchase a birthday gift or a Christmas gift. Those events happen every year and should not be a surprise.
Deciding on an Amount to Save
Financial analysts urge people to have at least 3 months of their basic expenses saved up for an emergency.
This means that if you were out of work due to illness, downsizing or any other reason, you could pay your utilities, groceries, mortgage, and basic debt payments for at least 3 months all from your emergency fund.
Ideally, you would like to have enough saved up to protect you for at least 6 months, but a 3-month amount is a good starting goal.
Saving Up the Money for the Emergency Fund
For most people, the amount to cover 3 months’ worth of living expenses will be quite a bit of money. In many cases, it will likely be a few thousand dollars.
That number may sound overwhelming right now. But with a bit of discipline, planning, and time, you can reach that number and add some peace of mind that you may not have experienced before.
The easiest place to start is by looking at all the ways you currently spend money. If you are the type of person that uses either a debit card or credit card or some combination of the two to pay for all your bills, this will be an easy exercise. Simply look at all the transactions for the past month from your statements and identify what they are.
Assign every expense to a category such as housing, automobile repair, automobile maintenance, groceries, clothing, utilities, dining out, entertainment, debt, etc.
Once you have everything labeled for at least one month, analyze each item. Determine if each item is a necessity. Eliminate anything that you do not need to survive.
Then, for all the necessary items like grocery, utilities, and the like, see if you can find a way to reduce any item. Even if you only reduce the item by 2%, a lot of these reductions can save you quite a bit of money.
After you have classified your expenses and found ways to eliminate needless spending, you can start to search for ways to add extra income.
If your job pays overtime, ask if you can work an extra hour or two per week. Each month, this will bring in some serious money.
If that is not an option, look for small side jobs. Babysitting, yard work, food delivery, and selling handmade items online are all viable ways to bring in extra cash.
Even a 2nd part-time job, such as working at a retail establishment, can bring in quite a bit of cash if you save most of it towards your emergency fund.
And remember, this is not a permanent change to your routine. This is something that you will be doing for a few months, maybe a year or so, to save enough for the emergency fund.
Deciding Where to Hold the Emergency Fund
Remember that the emergency fund needs to be in a place where you can get to it easily when something happens. You also want the money to be protected. That means stashing the cash in your sock drawer or under your mattress is out of the question.
It also means that you don’t want the money tied up and difficult to access, such as with a CD account or stock market investment.
Some people will save that the safest place to put the money is in a simple savings account at your local bank or credit union.
However, the interest rate on these accounts rarely keeps up with the average inflation. That means that over time the money will lose value.
A better option would be either a money market account or a Roth IRA.
The Roth IRA account will allow you to withdraw amounts equal to your contributions and not be subject to any penalty.
For example, if you opened a Roth IRA account with $1,000 and then saved another $2,000 in that account over the next 12 months, you could withdraw up to $3,000 at any time without paying any IRS penalty.
A money market account will have a slightly better interest rate than a savings account and will allow payments from the account either through a check or a simple transfer to a checking account.
Can’t I Just Use My Credit Cards for an Emergency?
While a credit card can be a good idea for an emergency, it can also backfire.
Suppose you lose your job due to a change in the economy. Your credit card has a high enough limit that you can cut down your expenses and use the credit card to pay for the necessities for 3 months.
But after 3 months you have no new job. And to add insult to injury, you now have a credit card that is maxed out with no way to make payments on the card or your living expenses.
A credit card could be used for an emergency if you had a solid plan to pay it all off within 3 to 6 months. But a better option is to simply save up the money for the emergency fund.
Top Reasons Why You NEED an Emergency Fund
If the previous discussion did not convince you, here are even more reasons why you need to save up an emergency fund.
- Self-Employed – If you do not have a steady job that will pay you when you are sick and provides paid time off, you need an emergency fund. One small mistake could cause you to lose your most important client. Even worse, a physical injury could force you to stop work completely while you recover. An emergency fund can also protect you during lean months if your workload is higher in certain months.
- You are a Homeowner – If you own a home, many things can either break down or stop working and need a major repair or complete replacement. Here is just a shortlist of things that may need replacing over the next 10 years. Any one of these items can be a few hundred dollars to several thousand dollars in replacement costs.
- Water heater
- Heating and air conditioning unit
- Garbage disposal
- Fill lines for the septic tank
- Roof insulation
- Medical Conditions – If you or a loved one in your home lives with a medical condition that causes you to make frequent trips to the doctor, schedule procedures, and pay for prescription medicine, you may exceed the annual deductible on your insurance plan. That might mean additional costs for you above and beyond the insurance plan. The extra doctor visits and procedures could force you to use your available sick time and even miss work without pay.
- Depending on a single source of income – if you live in a home that has one source of income, then you are one bad day away from needing the money set aside in an emergency fund. A car accident that puts you in the hospital for a few weeks, or an illness that sidelines you for an extended period, or the company that you work for closing its doors for good could all happen and any of these events could seriously financially hurt you.
- Your favorite relatives live a long way off – if you have moved away from your parents, siblings, or any other relative that means a lot to you, you would be devastated if something happened to them and you did not have the money to visit them on the spur of the moment. Between booking a flight, getting a hotel room, and money for food while you travel, a quick 3-day trip to visit your loved ones can be quite pricey.
- You are working towards a financial goal – if you are also saving up to buy a home, or a big vacation, or to start a business, you might be tempted to use up the savings for your goal in the event of a financial emergency. Having a separate account that is reserved only for the emergency and one that is only for your big goal will help you reach your goal faster.
Any one of the above situations points to your need to review your budget and develop an emergency fund.
Still Cannot Decide?
If the previous discussion did not persuade you to start working on your emergency fund, then consider these questions. If you answer no to most or all these questions, then you need to get to work on that rainy day fund.
Do you have a healthy 401k plan? Most 401k plans will allow you to take out a loan, using the balance as collateral. However, some plans require you to pay the loan back before you get a 2nd loan. So, if you have some kind of emergency and dip into your 401k plan, you cannot use that plan again until the loan is repaid in full.
Do you have multiple sources of income? If you have a primary job, some money coming to you from a rental property and some dividend or interest coming to you from investments, then you might be able to withstand one or two minor calamities without an emergency fund.
Do you work in an industry with high demand? Certain fields, such as the medical field or IT, have been in demand for years and the demand continues to increase. Even if you were to lose your job because of some weird reason, as long as you have a good personal work history, you should be able to find work again relatively quickly.
Summing Up Why an Emergency Fund is Important
If you find yourself in a tight spot, an emergency fund can be a great comfort source and help you be more mature about your finances.
Additional Helpful Real Estate Resources:
Saving money for an emergency fund is important but before you do that, saving money for a down payment may need to come first. This post by Sharon Paxson highlights some of the best ways to save money, which then can be carried over for saving money for your emergency fund.
Buying a home is exciting but if you’re not careful, mistakes can be made. Take a look at this article by Lynn Pineda to learn how to take the emotions out of buying a home to make sure you are actually buying a home that will work for you and your family. There are things to consider and Lynn does a great job of going through each in detail.
If you are a first time home buyer, there are probably a ton of questions you have about the entire process. This post by Kyle Hiscock goes through what are the most important questions you should be asking. Saving for a down payment is right up there with being able to qualify for a mortgage. Answer these questions honestly, and then fix or work on the things you need to be able to qualify for a home purchase.
One of the larger hurdles to overcome is getting a mortgage without private mortgage insurance. Unless you have a 20% down payment, there is a good chance you will be paying a part of your monthly payment towards mortgage insurance. Bill Gassett goes into the details of how to avoid private mortgage insurance and also how to get rid of it.
About the author: This article on “Why an Emergency Fund is Important” was written by Luke Skar of MadisonMortgageGuys.com. As the Social Media Strategist, his role is to provide original content for all of their social media profiles as well as generating new leads from his website.
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