But what constitutes an emergency? When should you tap into this fund?
The best way to answer this question is to first create a list of expenses that should not be emergencies.
Annual Expenses: Many people are caught off-guard by major once-a-year costs like their property tax bill, additional income tax they owe, renewing their car registration and buying holiday gifts.
But these aren't emergencies. You know that you'll have to pay taxes once a year. You may not know exactly how much money you'll owe for taxes, but you know that you'll have to pay something. You should budget a little bit of money each month for this bill.
Occasional-But-Predictable Expenses: Some people use their emergency fund to pay for expenses that are predictable in nature, but not in time.
For example: You know you'll have to pay for major car repairs at some point. You don't know when this will happen. Your car may break down this year, or it might not break down for another three years.
But you do know that, at some point, you'll have to put money into fixing your car. This is an expense that's predictable in nature, but not in timing.
This is also true for needing to replace your car completely. At some point in the future, your car will break down to the point at which it's no longer worth fixing. Instead of raiding your emergency fund to buy a new car, start making a car payment to yourself right away.
The same is true for replacing your washing machine, water heater, air conditioner, dishwasher, and the leaking roof on your house. You don't know when your roof will spring a leak, and you can't predict when your refrigerator will break down. But you do know that at some point in the future this will happen. The event is predictable, the timing is not.
Ideally, you should NOT use your emergency fund to pay for these types of expenses. You should set aside a little bit of money each month that allows you to pay for these repairs and maintenance issues when they arise.
Unpredictable Expenses: While you hope for the best, sometimes unfortunate events happen that you can't predict.
You and your spouse might both lose your jobs at the same time. You may have a major medical catastrophe, and your insurance refuses to pay the bill.
These types of events are truly unpredictable. This is what an emergency fund is meant to cover.
The reason that most financial experts recommend building emergency fund that covers at least 3 to 6 months of living expenses is because they anticipate that you will need to tap into this fund if you suffer a major job loss. They want the fund to be big enough to cover several months of bills while you look for a new job.
Reserve your emergency fund for these kinds of once-in-a-lifetime catastrophes. In the meantime, incorporate "saving for home repairs" or "saving for car repairs" into your regular budget.