Emergency Fund Basics: The Step On Which All Other Success Is Built

If you are just getting started with the “getting-my-financial-act-together” bit, you might not know where to begin. Have I got good news for you. It’s time to cut through all the clutter and for you to realize one important truth. The first step to success in all other areas of personal finance is creating an emergency fund of cash. Then you need to save it for a crisis.

emergency fundThat may seem like a bold statement. I can attest though, from personal experience, having money set aside strictly for emergencies is the #1 strategy that has propelled my wife and I forward in paying off debt, saving for retirement and college and investing in the stock market.

Why is that you ask?

Because it’s a fact – emergency situations in life are going to come. We cannot escape them. So it just makes sense that we learn how to manage through a crisis.

If we don’t have cash that is easily accessible to take care of the emergency the moment it hits our door, then we are really only faced with one alternative – going into debt to deal with the situation. And it’s this constant accumulation of debt that hinders our ability to accumulate great wealth over time.

You must break the going-into-debt-to-solve-the-emergency cycle.

In this article, I’ll outline the basics of having an emergency fund. You’ll learn when to start one, what to use it for, how much to save and the best ways to fund it.

What is an emergency fund?
As you’ve probably already guessed, an emergency fund is an account where you accumulate savings for when an unexpected crisis hits. A traditional savings account at your local bank is the best place to keep this money. You don’t want to keep a large amount of cash sitting around the house. Banks offer more safety for your money.

In what instances should I use the emergency fund?
You will use your emergency fund all the time. “All the time” for us has meant several times each year.We’ve used our emergency fund multiple times to replace appliances around the house, fund car repairs, fix heating and cooling units, and deal with medical expenses.

Here is the key to figuring out when it’s OK to use emergency funds. Use them in any situation that creates a daily hardship that is excessive. Of course that definition is subjective based on a person’s definition of “excessive.”

For example, fixing a car so it can be driven to work is an emergency. You have to work to make money. Thus you have to fix the car no matter what. A malfunctioning furnace or a broken arm certainly qualify as candidates for emergency fun use.

Issues such as fixing a broken dishwasher, replacing a faulty video game system or repairing an inoperative garage door do not qualify.

Why are these circumstances different? The first three create immediate conflicts that alter life. The others create inconveniences that can be managed for a time until sufficient funds can be saved to correct the issue.

One final note here – the emergency fund is also clearly not a late night pizza fund, an “I want that new couch” fund or a “Hey, let’s take a spur of the moment vacation” fund. Those are wants, not needs. To deal with these situations create a monthly budget or a more involved long-term savings plan.

When should I start an emergency fund?
This is simple. It’s the first step. All other issues are secondary.

You simply must have funds available to manage a crisis or all other financial goals will fail.

The emergency fund serves as the basic building block, the foundation of any sound financial plan. All other goals like paying off debt, saving for retirement or funding the kid’s college can come later. Once the money is saved to deal with a crisis, the funding of these other goals tends to pick up steam because you are no longer going into debt on your credit cards to handle the emergencies.

How much should I save in the emergency fund?
The answer to the above question depends on where you are in your financial journey.

In the beginning, you should have at least $1,000-$2,000 saved. This amount provides enough of a cushion to cover most emergencies. Once this amount is accumulated, you can move on and aggressively pay down all non-mortgage debt.

Increase the emergency fund to 3-6 months of expenses once the non-mortgage debt is paid. Any less than three months and there is a risk of not being funded enough should multiple emergencies hit in a close time span. Any more than six months and the risk is having too much money locked into a low interest paying asset instead of funding other investments (i.e the stock market) that would yield higher returns.

We capped our emergency fund when we reached 3 months of total expenses. At that point we discontinued growing it and only ever fund it now to replenish what we’ve taken out for an emergency. We felt three months was adequate for our family because we have other investments to draw on to fund any crisis that might extend beyond three months. For someone with no other investments to draw on, I would recommend funding it to the 6 month limit.

Now having that much in savings may feel frustrating for some. “Couldn’t that money be put to better use?” we ask. I know I’ve felt that way at times.

To combat that I look at our emergency fund like I look at an insurance policy. I don’t like paying insurance premiums either but I know having insurance protects me from catastrophic events. And that’s a good thing.

So like our personal insurance policies, the emergency fund serves as a sleep-well-at-night-fund. I’m relaxed knowing I have money for whatever emergency comes my way.

How can I quickly build my fund?
In order to build our emergency fund we started doing a monthly budget. We stuck to it with discipline and focus. The impact of our budget is that it helped us to spend less, which in turn caused our savings rate to skyrocket. Honestly, it was no trouble accumulating three months of expenses for our fund once we started doing a budget.

Other ways to build the emergency fund quickly might be to sell some personal items, get a part-time job for a short time frame or cut unnecessary household expenditures like cable TV and eating out.

In fact, if you do this right, you might be able to save one thousand dollars in just one month. Sound crazy? Click on the related content link below to see how it can be done.

What will this ultimately do for me?
The biggest financial benefit to the emergency fund is that it keeps you from going into debt to solve each crisis. Having the ability to stay out of debt is key to reaching long-term financial goals.

The biggest personal reward that comes from having an emergency fund is that it brings peace of mind. I can rest easy knowing that major life issues can be handled with cash. I don’t need to get all worked up and fuss over emergencies. All I need to do is handle them and move on.

Your next emergency might be right around the corner. If you haven’t already, start your fund today.