An emergency fund is an account that's earmarked for spending on urgent, unplanned situations only. It's intended to be used only for worst-case-scenarios.
Emergency funds are normally held in savings accounts or money market accounts, though they can also be in checking accounts. It is important that they are held in a liquid account so that they can be accessed quickly.
Who Needs One?
Most experts agree that everyone, regardless of socioeconomic class, needs an emergency fund.
Banks and other financial institutions don't label accounts as "emergency funds." That designation exists only inside the fund owner's mind.
How Large Should It Be?
Most finance experts recommend saving an emergency fund that's large enough to cover 3 to 6 months of expenses. That will help you get through the first few months of a job less, they say.
Other financial experts go a step further, saying you should have an emergency fund that covers 6 to 12 months of expenses. That will help if multiple bad events happen at the same time, such as a job loss coupled with a huge hospital bill.
What If I'm In Debt?
Experts are similarly divided on how large an emergency fund a person should grow if they're currently in credit card debt. Some experts say that a person who is in high-interest credit card debt should save a $1,000 emergency fund, then turn their full attention to paying down their high-interest debt, and then build the remainder of their emergency fund once their debt is paid off.
Other experts, however, believe that all people should have an emergency fund representing at least three months of expenses, even if they are in high-interest credit card debt already. These experts argue that the emergency fund will be available in case the person finds themselves in a tough spot and lines of credit are closed to them.
(As a side note, retirement savings accounts are generally NOT considered emergency funds, even if you're permitted to withdraw the principle contribution.)
Later, a significant emergency takes place. Perhaps he loses his job, his car gets stolen, or he break his leg and his insurance refuses to cover the bill.
Under other circumstances, John Doe would need to go into debt to pay for this emergency, by borrowing from friends or family or relying on his credit card. But instead, John uses his emergency fund to cover the bill, avoiding debt.
Once the crisis has passed, John's top savings goal becomes re-building the balance in his emergency fund.