How to Maximize the Effectiveness of Your Emergency Fund

How to Maximize the Effectiveness of Your Emergency Fund September 12, 2012

Everyone knows that financial experts suggest you have an emergency fund. That’s because when major, unexpected life events happen, such as a job loss or blown car engine, you don’t want to depend on credit cards to bail you out.

If you use debt to cover these emergencies, you’ll be going in the wrong direction on the road to building wealth. For this reason, a strong foundation for your financial house should be made up of a well-funded savings account, which is used just for emergencies.

Borrowing money is generally a bad idea. After all, who wants to pay interest?

But the worst time to borrow is when times are bad. If the economy is doing poorly and you lose your job, you don’t want to be drowning in debt. How much harder would it be to make minimum payments, let alone get out of debt, when you don’t have a source of income?

Fortunately, financial problems tend to occur less often when you have your emergency fund fully-funded.

What’s a Real Emergency?

An emergency is something you had no way of knowing was coming, and has a major impact on you and your family. Examples include:

  • paying a deductible on a medical, homeowner’s, or car insurance bill after an accident
  • medical bills resulting from an accident or unforeseen medical problem
  • a blown transmission in a car that you need to function

With that said, what are NOT emergencies?

A new TV is not an emergency. Wanting a new leather couch, or to go on a vacation to Jamaica is not an emergency. A nice dress for the prom is not an emergency. These are things that you should save for to purchase, rather than rationalize as emergencies.

Where Should You Keep Your Emergency Fund?

Your emergency fund should be kept in a liquid account that it’s easy to get to, without paying penalties or other types of fees.

This means that index funds, ETFs, or stocks are not good places, because you’ll pay taxes on any gains. They’re more appropriate for long-term investing. The purpose of this fund isn’t to make you rich. Your wealth building won’t happen in this account.

CD’s aren’t a good place either, because you’ll probably be charged a penalty for an early withdrawal.

The best place to keep the money for your emergency fund is a savings account that’s insured by the FDIC. It’ll be easily accessible to cover for emergencies, and you’ll even earn a bit of interest.

How Big Should Your Emergency Fund Be?

How much money should you actually have in your emergency fund? Figuring this out is more of an art than science. The purpose of this fund is to absorb risk, so the riskier your situation, the bigger the emergency fund you should have. Most financial experts say that a fund that covers three to six months of your expenses is the minimum amount you should have.

For instance, if you work on straight commission or are self-employed, you should build a fund that will last for six months. Likewise, if you’re single or are a one-income household, you should use the six-months rule. Why? Because in your situation, a job loss is a 100% loss in household income. And if your job situation is unstable for any reason, or if your family is dealing with serious medical problems, you should lean towards a six-month emergency fund.

But if you have a more “secure” job, you could lean towards a three-month fund. Everyone’s situation is different. Customize your fund to fit your circumstances. And if you’re married, don’t forget to take into account how your spouse feels about risk. Since the fund is for peace of mind, the spouse who wants the bigger fund should be given priority.

How much do you like to have in an emergency fund to feel comfortable?

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