An emergency fund is money set aside for unforeseen events such as sudden unemployment, short-term disability, a natural disaster or a major car repair. Having an emergency fund is a vital part of everyone’s financial plan; without an emergency fund an unexpected medical bill could put you over the edge and force you to incur debt or even lead to bankruptcy.
There is not a universal dollar amount recommend for an emergency fund; the amount varies based on your lifestyle. A general rule of thumb is to set aside six months of living expenses. Create a list and itemize your monthly expenses to help make a decision on the size of your fund. The list of monthly expenses also allows you to assign different levels of importance to each item. The most important and absolutely necessary expenses include mortgage or rent payment, homeowner’s insurance, auto loans/auto insurance, personal loans, medical or life insurance premiums, tax payments, utility bills, food, and transportation expenses. Secondary monthly expenses are clothing and laundry, child care, educational expenses, etc. The least vital expenses would be discretionary spending: entertainment and dining out, recreation and travel expense, hobbies, gifts, charitable contributions, etc. Understanding and ranking your monthly expenses will help if you experience a period of financial difficulty, you will already have a list of vitally important expenses and those expenses you might cut from your budget.
An emergency fund does not have to be large, but set up a realistic and manageable goal and start saving. If $1,200 is your goal, set aside $100 every month, after one year you have funded your safety net.
Your emergency fund should be somewhere you can access it quickly and a basic savings or money market account should suffice. Establishing a monthly direct deposit into this account should help to avoid temptation of spending your emergency fund on non-emergency items.
Keep in mind, your emergency fund is for unexpected liquidity needs, not an investment return. You should not tie your emergency fund to any form of long term investment vehicle such as stocks or bonds. You could consider a 3 month or 6 month CD, but I would not recommend longer than 6 month.
Building an emergency fund is not an exciting side trip on the path to financial freedom; but it is the very first step to achieving your financial goals. An emergency fund is a safety net and can keep you on the right track even if the unforeseen should strike.
Wenny Gorman, CFA®