Life is always full of craziness. Just watch the news for an hour, and you see stories of tragedies happening all over the world.
You can’t plan for or even avoid all the emergencies life is going to throw at you.
But what you can do is be prepared for them financially.
How can this magic happen? You are probably not asking, but I will answer this question anyway!
What Is an emergency fund? And why you need one.
The idea of an emergency fund.
Emergency funds are a simple idea, but infinitely harder to put into practice. It should not be that hard to put this concept into practice, but the constant barrage of advertising and pressure to spend money makes this hard for most people.
We are always chasing this skewed American dream that is now considered normal. People think they have to keep up with everyone else they see, buying the newest phone, the latest car, or a huge house they don’t need and really can’t afford.
Get out of that rat race now. Quit trying to impress people that don’t matter to who you are and where you want to be in 20 years. Focus on you and your finances now. Part of focusing on the now is having an emergency fund.
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To help you out we will cover:
- What is an emergency fund?
- Why is an emergency fund important?
- Why do you need an emergency fund?
- How much should you keep in an emergency fund?
- Where should you keep your emergency fund?
- What constitutes an emergency?
Why is an emergency fund important?
An emergency fund is simply an account you put money into and set aside for an emergency.
This account isn’t one you have access to for any other reason but a real emergency.
Saving sounds easy. Setting money aside and not spending it, shouldn’t be that hard!
But, what happens when you want the next newest item? Do you try and save the money for it, or do you take a little out of your emergency fund to pay for it?
I, mean the money is just sitting there, right? What harm could it do this time to take a little out?
The harm is, it is an emergency fund, not an “I want” fund. If you spend this money now, when an emergency happens you don’t have a safety net in place.
Building and maintaining an emergency fund takes a substantial commitment on your part. Be kind to your future self and start building an emergency fund today.
Why You Need an Emergency Fund?
So let’s say you are doing good. You have committed to pay off your credit cards and get yourself out of debt.
You’ve been doing an excellent job of limiting your spending and using that money to pay bills. Your car is four years old and has 45,000 miles on it. With one year left to pay on the car loan, you are feeling terrific about your financial situation.
As you are driving to work one day, smoke starts to leak out from under the hood. You pull over and call a repair service after they look at it you discover it is going to cost you $957 to repair.
Without an emergency fund, you are going to have to find a way to pay for this. Just like that your credit card debt is going to go back up. Not only do you have to pay for the car repairs, but any interest charged to you on the credit card you just used.
Another example is a medical emergency. You slip and fall on the ice in your driveway. A neighbor calls the ambulance and after an emergency room visit, ambulance ride, doctors fees, and medication.
You now owe $4,000 to the hospital. Insurance doesn’t cover any of this because you have a high deductible. You are stuck with the entire amount.
Add into this the cost of being out of work for an injury and not only do you now have massive debt, but you also can’t afford to pay your bills since you have no money coming in.
Having an emergency fund ensures that you have access to some cash in a situation when you are not able to work.
How Much Should You Keep in an Emergency Fund?
When you are first starting an emergency fund, Dave Ramsey recommends starting with saving a $1,000 while you pay off any other debt you have.
Is a $1,000 Enough?
Well, that depends. Is your income $2,000 or $4,000 a year? We know it isn’t. The average recommended amount for an emergency fund is three to six months of your household expenses. Expenses, not income.
If your average expenses are $40,000, this means your emergency fund should be from $10,000 to $20,000.
This savings ensures that in the event a traumatic experience happens to you, you have the financial means necessary to pay your bills without having to go into debt.
Having an emergency to deal with is hard enough without having to worry about how you are going to pay for things like food and mortgage payments.
Keeping an emergency fund not only helps financially but is a mental help as well. If there is an emergency, you can focus on that and not how your next mortgage payment is going to be paid. Once you are out of debt, continue to build your emergency fund to three to six months of your living expenses.
You don’t have to stop at six months. Build your emergency fund to a year’s worth of expenses.
Heather and I have a goal of keeping a years worth of living expenses in savings at all times. This savings is in addition to any retirement savings or Health Savings Accounts (HSA).
A fully funded emergency account is a lot of money to have around; you want to make sure that you are continuing to have your money work for you.
Where should you Keep Your Emergency Fund?
Having three to six months or a year worth of expenses just sitting around is a significant investment that you need to ensure is still working for you.
Most conventional brick and mortar banks do not offer an interest rate that is beneficial to you. Let me amend that, if you think earning between .01% to .05% on a savings account is profitable then you are in luck.
If you want to earn more interest than .01% on a savings account, you might want to look further than your local bank.
Many online banks offer a much higher interest rate on a savings account.
Heather and I use Discover banking for our savings accounts. Discover currently offers a 2.10% APR on their savings account. If you had $15,000 in a Discover savings account, earning 2.10%, in a year you would have earned $315.26; versus a $1.50 at a .01% interest rate for the same amount of money and time.
Using a savings account to keep your emergency fund separate and working for you is just one of the places to keep your emergency fund.
Related Article: The Easiest Way to Budget Your Money | 8 Bank Accounts
Certificate Of Deposit
Another option for an emergency fund is using Certificate of Deposits, or CD. CD’s usually offer a higher rate of return but require you to tie your money up for a set amount of time: from 6 months to 10 years. The longer the amount of time you sign up for the higher your rate of return.
Using what is called the ladder method, you open a 12 month CD in January with a $1,000, another one in February with the same dollar amount; you do this every month for a year.
This method leaves money in your emergency fund while earning a higher interest rate, as the CD’s mature, you can choose to re-invest in a new CD if you do not need the money at that time.
The ladder method allows you to have money on hand while gaining you a higher rate of return on your money. By investing money each month, after a year you have money returning to you each month. In an emergency, this would guarantee a source of income each month.
Most of us don’t think of using a Roth IRA as a place to invest our emergency fund. Though unconventional it does bear mentioning.
A Roth IRA is generally used much like a 401K; a means to invest for retirement.
Using your emergency fund money to fund your Roth IRA can allow more substantial returns on your money, assuming the investment options you choose, make money. Be aware that if the investments you choose, lose money, you can also lose your initial investment as well.
So why choose a Roth IRA as a place to keep your emergency fund? The potential for growth in a healthy market is much higher than a savings account.
Unlike a 401K, a Roth IRA is put in after taxes, allowing you to take out your initial investment amount without penalties; be aware any monies you remove made above the initial investment can be subject to penalties if the account has been open less than five years or if you are younger than 59 ½.
Health Savings Account, or HSA, can also be used as a place to put part of your emergency fund. Once you have your target goal reached, whether this is three months or six months, consider using your HSA as an additional emergency fund.
Health care cost can quickly add up to a debt you cannot handle if an emergency occurs. Having an emergency fund helps when being out of work. Using your HSA account as part of a medical emergency fund helps with using your main emergency fund to cover necessary living costs and not the medical cost associated with a medical emergency.
The contribution amounts for an HSA for 2019 have been raised to $7,000 for a family medical plan and $3,500 for an individual plan.
The good news about adding to your HSA account is the amount is pre-taxed, and this money can add up year after year. Maybe you are one of those super healthy people that never get sick and never will. For the rest of us, having a little extra money to pay medical bills will always be a good thing.
What Constitutes an Emergency?
Deciding what is or is not an emergency is something you need to decide before any emergency happens. Whether you are single or married sit down and write out a list of what constitutes an emergency to you.
This is especially important if you are married and building an emergency fund together. Creating a list between the two of you can help avoid problems down the line. Sometimes, creating two lists establishing what is an emergency and what is not an emergency, can keep you both focused on your savings goal.
Things that are NOT Emergencies
- Wanting the newest phone, or new clothes or a new car is not an emergency.
- Paying for a vacation is not an emergency.
- Buying a thousand lottery tickets because the jackpot is close to a billion dollars is not an emergency.
- An emergency is, your car breaking down unexpectedly and it costs a $1,000 to repair.
- A family member getting a ruptured appendix and having to stay in the hospital for a week.
- You or your spouse lose your job, and it takes three months to find a new job.
- A major house repair caused by a burst pipe or kitchen fire.
An emergency fund is to cover these costs so that you do not have to use credit cards or borrow money from others to get beyond the emergency.
Keep in mind; an emergency fund is for a dire need and not a temporary want.
Building and maintaining an emergency fund gives you peace of mind now for a time when money is not the problem you want to be focusing on.
How have you saved for an emergency fund? Let us know in the comments below; we love hearing from our readers.