[This post is part of the Financial Rules of Thumb series. Check out the rest here!]
I’m sure you’ve heard the term Emergency Fund in the financial media, but might not be certain what it means. Here’s a quick definition, and then my take on the topic.
Definition: Emergency Fund – Money that you can get your hands on quickly in the event of an emergency.
The Upperline: An Emergency Fund is one of the best things you can create, financially speaking. It sets a solid financial foundation and protects you from using high-interest debt. The question is, how much?
Your Emergency Fund can be in a savings account, money market, extra money in your checking account, whatever works for you. The important thing is that you have money available in case the transmission falls out of your car, the AC for your home goes out, or your home is temporarily damaged by a natural disaster. (But that probably won’t ever happen, right?)
If you don’t have money that you can access easily when bad things happen, you’ll have to
a) rely on friends/family/strangers
b) spend on credit cards or lines of credit.
If you’ve got these resources it’s not the end of the world if you rely on them in your time of need, but better for you if you can take care of the problem in advance by having sufficient cash. As I’ve said before, Cash is King not because it’s a great investment, but because it allows you to take advantage of opportunity or survive a small or large catastrophe.
“How much should I have in an emergency fund?” That’s up to you. This has more to do with you and your comfort with risk than anything else. If you have a stable, steady income and prospects don’t seem to be changing, then 2 to 3 months of expenses might make sense. If you have an income that can fluctuate, own a business, or are generally more conservative, then having 6 months or more of expenses makes sense.
“It’s going to be hard to save that much money.” Just because it’s hard doesn’t mean it isn’t the right thing to do. Set aside what you can every month, and create a visual tracking aid (like the thermometer that United Way uses) to chart progress towards your goal. Find a way to celebrate when you reach your goal.
If you don’t find a way to save small, regular amounts then you’ll never reach your goal without a big windfall of some kind.
But when that windfall comes, there’s another chance to do the right thing. Set aside some money for fun things, and use a big chunk to get closer to (or meet) your emergency fund goal.
With your emergency fund, you’ll have a resource that you can use, without high interest charges to pay for that new air conditioner. Then, you can then repay yourself rather than your credit cards.
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