I recently received a great question from a reader that I’d like to share. The reader asks:
“I hate paying overdraft fees ... (I) keep extra money in my bank account so I don’t have to pay these. Is this an emergency fund?”
Great question. The reader is asking if the cash cushion that she keeps in her checking account to protect against insufficient-fund penalties can be considered part of her emergency fund.
Short answer: no. Here’s why.
One of the top rules in personal finance is that you should maintain an emergency fund.
Most emergency funds should be able to cover 3 to 6 months of living expenses. If you have an unsteady job (such as a job in which your paycheck is highly dependent on commissions and bonuses, or if you’re a contractor or freelancer, or if you work in a shrinking industry), you may want to increase your fund to cover 6-9 months of living expenses.
This fund should be used ONLY to pay for expenses that shock you: a job loss. A hefty hospital bill. A large veterinary bill for a healthy, one-year-old dog.
In other words, an emergency fund serves the purpose of covering unexpected expenses. Any costs that you can expect –- such as car repair bills (every car will break down from time to time) –- should be paid from a fund specifically earmarked for that purpose.
What’s a Cushion?
A cushion, by contract, is a balance that you keep in your savings account in order to protect yourself against insufficient-fund penalties and overdraft fees.
“What does that mean?”
Let’s imagine that you have exactly $1,000 in your checking account.
On Monday, you write a check for $200, you pay your credit card bill online for $400, and you swipe your debit card to the tune of $400. By the end of the day on Monday, you have $1,000 worth of pending charges that will be deducted from your checking account.
Let’s say that the $400 credit card bill payment and the $400 debit-card payment both post on Tuesday. On Wednesday, you check your account and see that you still have $200 in there.
You’re a busy person with a lot of things on your mind; you forget that you wrote a $200 check that’s still pending. You assume that the $200 in your checking account is yours for the taking, so you withdraw $40 from an ATM.
Later that same day, someone tries to cash the check – but now you only have a balance of $160. In other words, you have insufficient funds. The check bounces and your bank charges you a $35 overdraft fee.
How can you avoid this? Keep a cushion in your checking account. Some people maintain a cushion that’s as small as $100; others feel secure when they have $1,000 stashed in their account. The less time you want to spend tracking your balances, the larger your cushion needs to be.
(Read more: Track Your Spending By Using Different Accounts)
This cushion is your baseline checking account balance. Once your checking account dips below that cushion, you should mentally consider yourself to be “overdrawn.”
You’re not technically overdrawn in the eyes of the bank; you won’t bounce any checks or get hit with any insufficient fund penalties. But once you dip below your cushion, you should consider yourself to hold a balance of “zero” in your own mind.
Using the same example as above: Let’s imagine that your “cushion” is $300. What would have happened?
First -- If you had $1,000 in your account, you’d never make $1,000 worth of payments on Monday. You’d mentally imagine that your bank account only holds $700, since the other $300 is the untouchable cushion. You might refrain from buying something with your debit-card on that day.
Second – If you did erroneously make $1,000 worth of payments on Monday, you’d notice your mistake as soon as you check your balance and see only $200 left in your account. That would set off an alarm in your head, since that amount is less than your cushion. You wouldn’t withdrawn money from an ATM. Instead, you’d scramble to deposit money into your checking account as soon as possible, replenishing your cushion.
The Bottom Line: A cushion is a small balance ($100 - $1,000) that you maintain in your checking account for the sake of avoiding overdrafts. An emergency fund is a large balance that you maintain in a savings account for the sake of bailing you out of a dire situation like a job loss. These are separate concepts; your cushion is not an emergency fund.