Emergency Funds: Why You Need One
Your car broke down and you need to pay $2,000 worth of repairs. You just got laid off and don't have next month's paycheck to pay the bills.
These unexpected financial challenges happen to the best of us and knowing you have an emergency plan in place can help you sleep well knowing you're ready when it happens.
What is an Emergency Fund?
An emergency fund is savings that you have set aside specifically to pay for unexpected events. These savings are separate from your retirement, education, or any other savings account you might have.
The purpose of an emergency fund is to supplement you when you have unexpected expenses or as a back up if you temporarily lose a source of income. This will prevent you from dipping into other savings that you've worked hard to put towards your goals.
How Much Money Should You Have Saved?
A practical emergency savings fund should have 3-6 months worth of expenses. Start by adding up all of your expenses for each month multiplying that number by 3 to total 3 months worth of expenses.
Start setting aside money each month to build your emergency fund. Once you have saved 3 months worth of expenses, working forwards 6 months worth of expenses will provide you with a nice cushion in case you have an unexpected event that prevents you from working several months.
Where to Keep Your Emergency Fund?
The main criteria to storing your emergency funds is to make sure your savings are liquid. What does that mean? It means that when you need to use funds they are easily and quickly assessible. Storing the funds in a savings or money market account where you can easily make withdrawals when needed is ideal.
When to Use Your Emergency Fund?
What qualifies as an emergency? Everyone may have a slightly different answer to this question, but following a practical criteria will keep you from misusing the funds so that they're there when you really need it. Ask yourself three questions:
- Is this expense unexpected?
- Is it urgent?
- Is it necessary?
If your answers to these questions are all yes then dipping into your emergency savings may be the best option.
If not, you may need to review your budget. If your expenses are exceeding your income, you may need to figure out where you can cut back on spending.
