Emergency Fund Definition
Emergency Fund Definition
Emergency funds are a necessary and important component of a good financial plan. They provide financial stability that protects your family from making choices in emergency situations that would otherwise have negative consequences. An emergency fund provides the peace of mind to know that should something unexpected happen, such as losing your job, you can worry about how to deal with the emergency itself and not worry about your finances. Since the financial crisis in 2008, many folks have become complacent regarding emergency funds, because investing their cash in the stock market was much more lucrative. But in a post-Covid world, with millions unemployed, and medical bills mounting for many families, emergency funds are critical.
What counts as an “emergency”?
Your emergency fund should be used only for the events that really upend your entire world. Most commonly, these are living expenses from job loss, unforeseen medical, emergency, or funeral expenses. Medical deductibles and unexpected surgeries are often a double whammy, because there might be also be a drop in wages during the recovery period. So, we are talking about true emergencies here.
College tuition is not an emergency.
Wanting to upgrade to a new car is not an emergency (but needing transportation to keep your job is!)
Buying a new house is not an emergency.
Home improvement is not an emergency.
Vacations are not an emergency.
If you apply the concept too liberally, you’ll constantly be depleting your fund, which defeats the purpose of its existence, which is to provide security during life’s worst moments.
How much do I keep in my emergency fund?
Emergency funds need to be tailored to your specific situation. Because the purpose of the fund is to pay for all your monthly expenses in the case of an emergency, the amount depends on your required monthly expenses (not your “wants”). Here are some general guidelines:
One income household = more risk
Two income household = less risk
Secure job = less risk
Unsecure job = more risk
High career turnover time = more risk
Poor medical history = more risk
I recommend a 3-month emergency fund for dual incomes with secure jobs, and a 6-month emergency funds for single income households, or those with some uncertainty about their prospects at their current position. Some careers have a naturally slow turnaround time for new positions, so its up to you to really understand your field and its hiring trends, as well as your marketability.
A 6-month emergency fund for a family with monthly expenses (mortgage, utilities, food, travel) of $2500 would be $15,000. I normally recommend to budget only for the actual necessities, because if someone in your family has an unexpected job loss or hospital stay, it’s probably in your best interest to limit the discretionary spending for a few months to help quicken the recovery.
Where do I keep my emergency fund?
Allocating money to your emergency fund should be the first step of any savings plan, because it is established prior to investing for retirement, college costs, or even for paying down your mortgage. It’s a form of protection and it needs to be established early in your personal finance journey. I recommend the following savings order for most people, though everyone’s situation is different:
1.) Establish a 3-6-month emergency fund in cash.
2.) Contribute to your 401k or other work-sponsored plan up to the match.
3.) Fill your IRA
4.) Go back and max your 401k contribution.
5.) Invest in taxable brokerage accounts.
Emergency funds should not be held in any type of tax-advantaged retirement account, or any illiquid asset like a CD or individual bond. Emergency funds should be liquid, meaning you can access the cash easily and without a long waiting time. Ideally, the funds should be accessible before you must pay credit card interest on money you’ve spent during the emergency period. Unfortunately, there are very few good options to combat inflation with interest rates at historical lows, but even with losing some money to inflation, emergency funds are important.
Good choices: high-yield savings accounts and money market funds.
Acceptable choices: checking accounts (though you will lose full inflation value each year on this cash), and low volatility bond funds.
Poor choices: CD’s, individual bonds, volatile stock, or equity funds.
It is possible to keep your emergency fund in a taxable stock account without too much trouble, as it usually only takes a few days to sell the assets and transfer the money back to a checking account. However, this is suboptimal as you might be forced to sell at a loss or create a taxable event.