Emergency funds are a hot topic amongst financial writers. How much do you need? How should you go about building one? Where should you keep it? It seems like every time you turn around, people are writing about the importance of emergency funds.
Despite all of the attention paid to emergency funds, relatively little attention is paid to when you should tap into yours. With that as a backdrop, I thought I’d tackle the following question that I recently received from a reader:
What should an emergency fund be used for? I have read several blogs and some seem to think that it should be used in the event of unemployment. Some other bloggers suggested that it be use for things such as car repair, house repairs, etc. What do you suggest?
That’s a great question, and there really isn’t a one-size-fits-all answer. It really depends on how you’ve set things up, and how far you’ve made it down the path toward financial security. In the early stages, an emergency fund will mostly be used to cover urgent needs that might otherwise negatively impact you physical or financial well-being.
Take, for example, Dave Ramsey’s Baby Steps for getting out of debt. The first step is to build up a $1000 emergency fund. That way you won’t be forced to whip out the credit card when your car breaks down, the furnace stops working, etc.
Obviously, a $1000 emergency fund wouldn’t go very far if you lost your job. That’s why the typical recommendation is to eventually build up three, six, or twelve months of living expenses (Ramsey recommends 3-6 months in Baby Step #3). Such funds are obviously capable of sustaining you and your family for an extended period, and are thus typically used in the event of unemployment.
This isn’t to say that you can’t or shouldn’t use some that money when your car breaks down, but it’s important to build the fund back up after tapping it. Otherwise, it will gradually run down and won’t be able to sustain you when you really need it.
Of course, there are all kinds of answers in between. For example, you might have a main emergency fund with several months worth of expenses saved up, as well as “satellite” funds earmarked for car repairs, home repair, etc. If this sort of system sounds attractive, you might consider opening an account with ING Direct, as they allow for the easy creation of subaccounts accessible through a single login.
A couple of notes:
First, because of the importance of being able to access these funds in a pinch, you should keep them in a savings account or no penalty CD. Alternatively, if you have a fairly large emergency fund built up, then you might consider building a short-term CD ladder with your money spread across (say) twelve 12 month CDs.
Second, it’s important to recognize that certain things, no matter how inconvenient or uncomfortable they might seem, are not emergencies. In other words, if your car break down and you can’t get to work, that’s an emergency. But if your TV breaks down and you can’t watch your favorite TV show, that’s not an emergency.