There are some that suggest you don’t need an emergency fund at all and a credit card or a home equity loan would suffice. For those who offer that advice: I think you are crazy. Why would any logical person go into further debt in an emergency? The old maxim an ounce of prevention is worth a pound of cure is dead on. Not planning and saving for some kind of emergency (even if it is small amount like $500-$1000) is absolutely essential because you never know when it is going to rain and believe me it will rain. It has rained at least once in the past three months and I am glad I had emergency money set aside to help take care of that situation. So there is no doubt that you need an emergency fund of some kind. However, there are several questions surrounding emergency funds.
Question 1: What is considered an emergency?
For me, emergency funds are not to be used when you have small unforeseen expenses, like you didn’t budget this month to go out to dinner or something of that nature. Emergency funds only should be used for true emergencies. Perhaps, your car engine blows up or you lose your job and need to stay afloat until you find another one. Emergencies are those unforeseen items that come up where you have a great need to be taken care of (e.g. transportation or paying the mortgage without income). They don’t happen often, but they do happen and need to be planned for.
Question 2: How much should you have in your emergency fund?
The exact amount differs for different people. Financial gurus will recommend a fully funded emergency fund to consist of expenses that range anywhere from 3 months to 1 full year. For me, my ultimate goal is about three months of expenses because I have a secure job. However, right now I have about $1000 in my emergency fund because I am in debt payoff mode.
Question 3: What qualifies as expenses for your emergency fund?
I think this is perhaps one of the hardest if not the hardest question to answer because when you are creating an emergency fund you have to figure out what your expenses are each month and then use that as a basis to create an amount you are comfortable with. What qualifies as potentially emergency expenses? Some are fairly obvious like mortgage or rent, electric, food, phone, gas, and maybe a couple of others. But what about things like student loan payments, credit cards, car payments, or other payments. In my opinion those are not necessarily emergency items to put in your budget for an emergency fund. I mean if you lose your job and might be out of work for an extended period of time you probably aren’t going to be able to pay your credit card anyway so that would one of the last things on my list. I try to keep my emergency fund expenses to the basics of life, but I can understand why others would include a car payment, student loans, or other items in that list. It is really up to you what you are comfortable with. For me, it is the basic necessities of life.
Question 4: Where do you put your emergency fund?
This is the other difficult question for me. Some people recommend that you have that money sitting in a bank account accumulating interest at .5%. The idea is that those monies are liquid and easily accessible.
My problem with that recommendation is two-fold. First, I hate to see my money only earning a small amount of interest like that. Second, I might be tempted to use those funds to pay off debt or something else. Thus, I would be spending my emergency fund. So my solution is two-fold.
First, I have about $1000 sitting in bank account that I can get access too fairly quickly. The thing is that emergencies rarely require you to pay X amount of dollars right away. Most of the time those emergencies involve expenses that will come in and you don’t have the income to pay for them because you lose your job or you were not given enough money or whatever.
Second, the rest of the money I am putting into my ROTH IRA. I love Roth IRAs and believe everyone should have one. I wish my job offered a Roth 401k because I would be the first to sign up. There are a number of great things about Roth IRAs.
1) When you contribute to a Roth IRA all of the money you contribute and invest will grow TAX FREE!!! Woo HOOO! Now any gains you have on that money you can’t take out until you reach 59 ½, but those monies grow TAX FREE!
2) Any gains that you have in your Roth IRA you do NOT have to take a monthly distribution at 70 1/2. In a regular IRA or 401k or other retirement account you have to take a mandatory distribution when you reach that age. With Roth IRAs you never have to take that distribution. So you can pass that money along to heirs or others if you want.
3) Once you have owned that Roth IRA for five years you can access up to $10,000 that you can use to buy a house. That is a fantastic feature.
4) The most important thing for emergency funds is that you can withdraw the contributions you make ANYTIME! No questions asked. Now you CANNOT withdraw any kind of interest or gains you have earned from your contributions, but your basic contributions (up to $5500 per year) you can withdraw. So let’s say you contribute the maximum each year and you have say $20000 in contributions. You access that $20000 for an emergency. Because a lot of emergencies might involve protracted unemployment or bills that might not require money immediately it doesn’t take long to contact the company you have your Roth IRA with and request your contributions be sent to you in a check or transfer the money into your bank account.
The Roth IRA is one of the BEST, if not the best, way to save for retirement and/or keep your monies safe for an emergency fund. I only wish that I could contribute more every year.
So my two-tiered solution gives me immediate access to a small amount of money if needed and then if I needed to tap some money for a long-term emergency I will be able to get access to those funds fairly quickly.
I think everyone should have a Roth IRA. They are easy to open and the vast majority of Americans can open one up. Now if you make hundreds of thousands of dollars every year you might not be able to too, but the 99% or 95% should have no problem.
The key to any emergency fund is that those monies are for emergencies ONLY! Not for debt payments, not because you had a slow month with wages, not because you want a new car. I have a high threshold for what I consider to be an emergency. If you plan a little now you can be prepared when the rain truly comes.