Years ago I learned a simple expression that made a sizable difference in my financial life. It was the expression “Plan for the worst, hope for the best.” My optimistic wife might say that using a phrase like this is pessimistic but I like to call it realism. Life can throw many things at us. We are unfortunately not all-knowing, and in today’s economic climate it’s easy to get caught off guard. An emergency fund is the answer to such uncertainty. The thought behind an emergency fund is the same as home insurance; both protect you from unmitigated risk in the event of an emergency.
What Exactly is an Emergency Fund?
An emergency fund is what it sounds like – a lump sum of cash that you can access in the event of an emergency, such as loss of a job or an unexpected medical issue. Now, people can debate what a true emergency is, but what we are talking about here is something along the lines of losing a significant source of income or family emergency. Personally, I can remember when my step father, who was in the military at the time, was called up to active duty, but through a chain of events ended up not going active. The result of him not going active meant that he did not get paid his salary for four months. Thanks to his and my Mom’s emergency fund, they were able to make it through that stressful time.
How Much do You Need?
Most experts say that you need at least three months if not closer to six month’s worth of living expenses saved to have an adequate emergency fund. Some are even arguing for the need for a 12 month emergency fund in light of today’s financial climate. More is better but it takes time to get to any of those milestones if you’re starting from zero. If you don’t have an emergency fund set up, now is the time to do it.
Surprisingly, many do not have such a fund to fall back on in times of emergency. A recent study shows that only 38% of Americans have an emergency fund. Living in a saving-adverse culture and a weak economy make it easy to put off starting an emergency fund. However, living a frugal life calls us to make choices that can help further us along the road of financial freedom.
Where do You Start?
The short answer is through saving. You might be thinking “I’ve just begun saving and do not have much built up”. If you’ve automated your savings, that is a great place to start. If you want to establish a basic savings account before diverting money to an emergency fund, set a goal of $500 or $1000 and then start supplying cash to your emergency fund. Calculate your necessary expenses (mortgage/rent, utilities, groceries, gas, etc.) and multiply that by three, six, nine or 12 and direct funds each month to your emergency fund account until you reach that amount.
How Should You Invest It?
Three months of living expenses is not a small amount, nor is six months for that matter so you will want these funds to work for you. Savings accounts, money market mutual funds and short term bond funds are all viable investment options. Liquidity is of utmost importance, so be wary of sacrificing it for a better return; you don’t want to find yourself in immediate need for some of the funds and not be able to access them.
The real beauty of an emergency fund is peace of mind. Yes, it does require sacrifice to establish and will not be fully funded overnight, but the reward is well worth the sacrifice.