Continuing with the steps to financial freedom today we are going to talk about emergency funds. Nobody can predict the future, so you don’t know when you will need access to emergency funds. I can tell you that almost everyone at some point in their lives will need money for an emergency situation; therefore everyone should have an emergency fund. We have had to tap into our emergency funds a handful of times during our adult lives. In this article we will go over these topics:
- What is an emergency fund and why you need one
- How much emergency money should you have
- Where to keep your emergency fund
- What we do for our emergency fund
What an Emergency Fund Is and Why You Need One
An emergency fund is exactly like it sounds: money that is intended to be used for emergency situations. The emergency situation could be a car breakdown, sudden travel needs, or maybe a loss of employment. The fund is a safety net so that you don’t have to turn to credit cards or loans to take care of whatever the situation is. It also gives you peace of mind that if something urgent were to come up you can financially withstand it.
It is important to remember that an emergency fund is there for emergencies, not because you see something you want to buy right away. To help determine what qualifies as an emergency ask yourself these questions:
- Is the situation unexpected?
- Is the need urgent?
- Is the emergency money truly needed?
If you answer yes to all three then it probably is worth tapping into your emergency fund. If your car windshield gets hit with a large rock, needs replaced, and you have to pay for it is that an emergency? I say yes; it was not expected to happen, the windshield needs fixed as soon as possible, and you need the car for transportation. Seems like a very good reason to spend emergency fund money. One of my best examples is when we moved to our first duty station but we had still not sold the house we lived in before the Navy. All the sudden we were paying for our duty station house and a house we did not live in at the same time. You can bet we used emergency funds to help with that problem and it was a damn good thing we had the money available.
How Much Emergency Money Do You Need
The amount of emergency money you need depends on several factors such as:
- How much money you need for monthly expenses
- How stable your job is
- How many dependents rely on you
To get an idea how much emergency money you need first look at how much you spend each month on essential items. If you have created your budget this should be a fairly quick process. Essential items typically include:
- Food
- Housing
- Transportation
- Bills and Insurance
Add those up and the total is your baseline monthly expenses. Many financial planners will recommend 3-6 months’ worth of expenses for an emergency fund, but that is a recommendation for everyone in general. You may want to have more or less depending on your personal situation.
One benefit of being active duty is we have very stable jobs; the possibility of being fired or laid off is very small. If you have not worked in the private sector you may not realize how stable our jobs are. However, consider your spouse’s job if applicable. What if he/she were to lose their job?
It is also important to consider your dependents when figuring out how much emergency money to have. A family of four with only the military member working is probably going to want more emergency money than a single person living in the barracks.
Consider the above points when determining how much emergency money you need. If you are just starting, a great target for an emergency fund is $1,000; this should be enough to get you out of many common financial tough spots. For military members I recommend 1-2 months’ worth of expenses for your emergency fund. If you have a spouse with a job you may want more, or if you are getting close to getting out of the military you probably want more.
We currently keep 2 months’ of expenses in our emergency fund, but we used to keep more. We based the amount on a worst case scenario where I didn’t get paid for a month and we had an immediate need for expensive travel (a death in the family as an example). Both of these are very unlikely to happen at the same time, so we feel comfortable with the 2 month number. In the times we have had to tap into the emergency money we have not used even half of it, so for now it makes sense to have 2 months’ expenses.
Where to Keep Your Emergency Fund
Keep your emergency fund in an account that is safe and that you can get access to quickly. It is a very good idea to keep your emergency fund in a separate account, or even separate banks, than your normal savings account. This helps avoid the temptation to spend the emergency fund money. Options for an emergency fund are high yield savings accounts, a checking account, money market or a Certificate of Deposit (CD).
You can certainly use a checking account for your emergency fund, but keep in mind interest on checking accounts is next to nothing. Money markets currently aren’t competitive with a good savings account when it comes to interest. A CD could net you a bit more interest than a savings account, but if you have to withdraw the money early from a CD you will get charged for it.
I recommend a high yield savings account for your emergency fund, especially if you are just starting to build one. High yield just means that it earns a good interest rate for you. The reasons for my recommendation are:
- Savings accounts are insured by the FDIC
- You can access your money quickly and easily any time without penalty
- Interest rates are better than checking accounts and equal to many money markets and CDs
- Many savings accounts are available with no fees or minimum amounts
Most high yield savings accounts are with online banks, but feel free to shop around. The only disadvantage to most online accounts is that you have to move the money to your primary bank, which means it may take 1-3 days to make the transfer. This may be a good thing if you are easily tempted to spend money; not having it for 2-3 days might give you time to reconsider a purchase.
There are some online banks that offer free checking accounts to go with a savings account. If you are comfortable waiting a few days for money to transfer then you have a lot more options; if you prefer to have the ability to write a check or use a debit card then you will need to do some homework to find a bank that has those features.
When choosing a spot to park your emergency money do not just look at the interest rate. Make sure the bank you choose does not have fees or restrictions, such as minimum amounts. If you want apps for your phone consider that as well; some online banks don’t have them. Ideally you should choose a bank that has no fees and low or no minimum required amounts. Some good online banks to consider are:
The above is by no means a complete list; it was just a few good examples to get you going. I don’t think you can go wrong with the ones I listed, but you can do an internet search for “best savings account” and come up with many more possibilities.
What Our Emergency Fund Looks Like
As I mentioned we keep 2 months’ of expenses in our emergency fund. Our emergency fund is actually split between an online savings account and a Roth IRA. I do not recommend this method for those just starting out. Only once you have all of your finances solidly under control would I recommend exploring methods like that, but I want to be totally honest and upfront with you. We will go over investing emergency fund money in a later post.
We have a Discover online savings account for half of our emergency fund. We chose Discover because they offer good interest rates, no fees and no minimum amounts. They also have great customer service; you can reach a person 24/7 if you have any problems. If we have to tap into the emergency fund I simply log into Discover and initiate a transfer to our primary bank; the transfer process takes 2-3 business days most of the time. That transfer process has never been a problem for us, but consider your personal situation and make your own decision.
Our plan for dealing with financial emergencies involves these 3 steps:
- If the situation requires immediate payment use a credit card. Credit cards are nearly universally accepted and I cannot think of a situation where a credit card would not cover the emergency.
- Within a day or two initiate a transfer from the emergency fund account in the dollar amount that we paid using the credit card.
- Once the money has been transferred pay the credit card in that dollar amount immediately. This ensures you won’t accrue interest charges.
This method has worked several times over the past few years, but you don’t have to follow it. If you are not comfortable using a credit card for emergencies then find a good savings account that offers a free checking account also. Then you can use a debit card or withdraw cash at an ATM. Come up with a system that works for you and implement it.
Conclusion
Hopefully now you know what an emergency fund is, why you need it and where to put it. Start with a $1,000 emergency fund and adjust from there. If you want to follow the method we use go for it, if not find your own system. The bottom line is you should consider an emergency fund a necessity and a priority. At least build up a $1,000 fund before tackling other financial goals. Good luck!
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