“Hope for the best, plan for the worst.” That famous saying summarizes why you need an emergency fund. Life has a funny way of throwing major expenses at you when you least expect it, and without an emergency fund, you’ll be forced to rely on a credit card to bail you out.
Why Do I Need an Emergency Fund?
Creating an emergency fund is your way of expecting the unexpected. You might be forced to tap your emergency fund if:
- A tree falls on your house, damaging your roof, and your homeowners insurance company charges you a $1,000 deductible plus a 20 percent co-insurance fee.
- You get into a car accident and your auto insurance will only cover half the bill.
- Your dog needs a $700 emergency surgery.
- You get fired from your job.
- A family member in another state or country becomes sick, and you need to fly there immediately.
- You need an expensive prescription, or emergency dental work, and your insurance won’t cover the total bill.
You get the idea.
What Does an Emergency Fund NOT Cover?
Your emergency fund is NOT meant to cover expected occasional costs. Your washing machine will break. Your refrigerator will stop running. Your water heater will need to be replaced. You can plan on these things happening.
Those are expenses you should budget toward. Your washing machine costs $300 and lasts for 8 years, which means that if you set aside $3.12 per month in your “washing machine replacement” fund, you’ll be prepared eight years from now. You may want to save double -- $6.24 a month -- so you'll be ready if that machine breaks four years down the road.
(Of course, it might feel silly to have a special fund just to replace your washing machine. You might want to lump all your home maintenance bills – replacing the carpets, buying a new lawnmower – into a general “maintenance” savings fund that you contribute to monthly.)
How Big Should My Emergency Fund Be?
Experts disagree on exactly how large your emergency fund should be. Most experts say you should save 3 to 6 months of your normal living expenses. Others advocate saving 6 to 9 months of living costs. A few go as far as to recommend saving 9 to 12 months of normal expenses, especially if you’re self-employed, if your income fluctuates (e.g. if you rely heavily on commissions or bonuses), or if you work in a declining industry with lots of layoffs.
Remember: if you do get laid off, there’s little chance that you’ll have zero income for a year. Chances are that you’ll at least pick up a part-time job or some freelance work while you’re searching for employment.
There’s also a slim chance that you’ll maintain your normal cost of living. You’re more likely to stop buying new clothes, taking vacations and eating at restaurants.
That said, it’s always possible you’ll be hit with many unexpected expenses at once. You could get fired from your job AND a tree could fall on your house AND your car engine could overheat AND your dog could need emergency surgery, all in the same week. It’s possible.
Ultimately, you should have an emergency fund that’s strong enough to provide you with peace of mind. Three months of living expenses is the minimum you should save.
What If I Have Credit Card Debt?
Of course, the purpose behind an emergency fund is to prevent you from resorting to high-interest credit card debt in case the unexpected happens.
What if you already have high-interest credit card debt? It doesn’t make sense to pay 15 percent interest on your debt, while you amass thousands in a savings account.
Most experts agree that if you have credit card debt, you should put aside a small emergency fund – perhaps $1,000 – and then throw every spare penny towards paying down your credit card debt.
Once your credit cards are repaid, focus on building that emergency fund so you won’t slip back into debt the next time adversity strikes.