I’ve heard financial planners talk about needing an emergency fund. I've known we needed one for a while. But overspending was preventing me from fully funding our rainy day fund.
Saving a rainy day stash of cash is difficult while having credit card debt. After we become credit card debt free, we will fully fund our rainy day fund.
Being financially responsible means that we are not living on a financial cliff. That we prepare to handle unexpected bills, while still pursuing our goals, as much as possible. By maintain an emergency fund, you are working your financial muscles and protecting your financial future.
What is an emergency fund?
An emergency fund, also known as a rain day stash of cash (or just rainy day fund), is meant to cover UNEXPECTED expenses. It is recommended to have 3-6 months of cash. Some people could probably get by with less. But it depends on what will make you feel comfortable if something terrible happens, and how stable your employment is. For example, if you are dual income household, you could probably get by with a smaller stash. Make sure you and your partner are on the same page with the amount that makes sense for you. I’m shooting to have somewhere in the 4-5 months of expenses put away.
Some articles create a number based on your income, but I think it’s better to use your base expenses instead. There are budget items that you can cut back on or eliminate when faced with a crisis. For example, I could probably cut back on my white chocolate americanos.
In calculating how much money you want, you will need to do the following:
- Know what your monthly base expenses are. Don’t count anything that you can cut during a hardship — the base things to include: mortgage payment, electricity, gas, minimal fuel costs, and minimal food costs. Here are some budget items we don’t include: dining out, allowances, internet, streaming services, and date night.
- Once you know your monthly base expense number, multiply that by how many months you want to cover to come up with your stash amount.
The goal is to avoid having to go into debt when the following happens:
- Losing your job.
- Unexpected medical or dental bills.
- Unexpected car replacement (more on this below).
- Major home repairs that are necessary. Things like a new roof that come up randomly (which hopefully is partially covered by your homeowner's insurance).
- Child/Pet emergencies.
If we don’t have an emergency fund, we scramble for ways to cover the extra costs. If you try to avoid going into debt, this might mean having to ask family or friends for money (which makes Thanksgiving dinner interesting). Dipping into your retirement fund could hurt you tremendously in achieving your goals.
Having insurance is not a guarantee all incidents will get fully covered. You have deductibles, and a claim might get denied.
Why do you need an emergency fund?
If you are living like things will always go as planned, you are preparing for disaster. For years I didn’t have an emergency fund, and unexpected expenses would go on a credit card, which made it hard not to continue going into credit card debt.
An emergency fund helps protect your financial future. Without a rainy day fund, we might have to rack up debt, which is not the kind of extra stress you need when you lose your job, for example. We never know what might happen in the future, but this adds a level of protection to you and your family.
What counts as an emergency?
The point of an emergency fund is not to touch it unless you have to. In other words, it should be your last resort, which would prevent you from going into debt.
One way to look at this is to cover the things are not emergencies:
- Overspending your food or dining out budget. It would be better to have a budget item to cover small overages in your monthly budget.
- Routine car maintenance, which can be difficult if you drive older vehicles since sometimes they require substantial repairs. One way around this is to have a “vehicle budget item” every month that grows, that you can also use to replace the car.
- Replacing your vehicle, unless you get into a car accident or when it's stolen.
- Going on vacation.
- Buying a 4K OLED TV.
- Extra Investing. Even if you think you are looking at a once in a lifetime opportunity, don’t touch your emergency fund!
- Buying a house. Becoming a new homeowner is not the time to dip into your rainy day stash of cash.
- Lending money to family or friends. This might vary depending on the type of relationship you have with your family. But your emergency fund is not meant to be a rainy day fund for your family. Even if they have the intentions of paying you back, if they are not smart with money, you can probably kiss that cash goodbye. A stash of cash is meant to cover YOUR OWN FAMILY and not extended family. I suggest not telling family and certain friends that you have an emergency fund to avoid awkward conversations.
- Funding a kitchen renovation.
If you do dip into your emergency fund, fund it as soon as possible.
To create a situation where you are not dipping into your rainy day fund every month for non-emergencies, you need to have a rock-solid budget that covers as much as possible. But even then, you will have extra needs that might come up, that aren’t significant hardships. I like to have a monthly budget item that I can dip into for things like this. If I am continually overspending in a budget category, that is probably a good sign that I need to budget more in that category.
The hope is that you will never have to touch your emergency fund.
Where do people store an emergency fund?
Some people like to invest their emergency funds in “reliable investments.” But this comes with several risks: 1) having to pull out the funds when the market is down and 2) sometimes the funds are not easily liquidated. I honestly toyed with putting our emergency fund into Betterment, but I was concerned that I would look at it as investment money.
Using HELOC has been mentioned as an option for an emergency fund. But going into debt is precisely what you don’t want to do when faced with an emergency.
I plan to store our emergency fund in a high-yield savings account. Especially considering you can get one with a 2%+ interest rate right now, this is a great option. Your emergency fund will grow with time, and it can be easily accessed. Eventually, I also want to open a HELOC as a “backup,” just in case I run through our emergency fund. That way I have access to lower cost debt under the worst case scenario.
You want to protect your rainy day fund like you would defend a child. If you are tempted to dip into it when you don’t have a valid emergency, put it in a place where you don’t have to see that number unless you want to.
Some of us have accrued massive amounts of credit card debt because we have not had an emergency fund, which compounds a bad situation. You want to avoid this like the plague. You will sleep better at night, knowing that if something terrible happens, you have some margin to work through it and protect your financial future as much as possible.
Having 3-6 months of base expenses available can relieve stress, and allow you to handle unexpected situations more confidently. Is it an excuse to take your time finding a new job? Maybe, but it should also motivate you to replace your income, so you don’t have to re-build your emergency fund as much.
It may take time to fund your rainy day stash of cash fully. Being smart financially means preparing for unknowns as much as possible. A rainy day fund adds stability to your financial picture. It is not a guarantee that things will be alright. But it is better than the alternative.
Do you have an emergency fund? If so, how many months does it cover and how is it stored?