Emergency Funds: Everything you need to know!
What is an emergency fund? An emergency fund is an amount of money set aside to be used only in case of an emergency. These emergencies could be for medical expenses, unexpected home or car repairs, loss of income, or a significant unexpected experience. What kind of emergency funds are there? I like Dave Ramsey’s approach to emergency funds. He lays out two kinds of emergency funds in his 7 Baby Steps Plan: a starter emergency fund and a fully funded emergency fund. Baby Step #1 is saving $1,000 as a “starter emergency” fund (click here to see his 7 Baby Steps Plan). Once you have your starter emergency fund, and after you complete Baby Step #2 (paying off all debt), you then start Baby Step # 3: save or a fully funded emergency fund of 3 to 6 months of expenses. There are also two additional “emergency type” funds that Dave recommends apart from the starter and full emergency funds. He recommends having a stock-pile fund for when you are expecting a baby as you prepare for all the additional expenses that will come up. The other is if you have uncertainty in the stability of your job in the very near future. In both instances, you would save up as much as possible and put a pause on whatever baby step you are on.
Another approach is called the Plan Ahead Method created by Kelsa Dickey, another expert financial coach. Instead of using a “starter emergency fund”, in this approach, you create sinking funds within your budget to account for those unexpected expenses that would be considered an emergency (car repair, medical funds, etc). A sinking fund is just another name for a future savings account for an expense. She also recommends having a 3 to 6 months emergency fund that can be funded while also still funding sinking funds if you are able to with any extra income.
I work with my clients to see what approach they are more comfortable using and help them set up the system that works for them and the timeline of their goals. Where should you keep your emergency fund? This money should be readily available in an account that you can access relatively quickly after the emergency happens. However, the money should not be so easily available that you can immediately transfer the money in a moment of weakness and spend it on a spur of the moment trip to FL or a birthday present for yourself.
I recommend keeping your emergency fund at a bank account that is different than your normal day to day checking account. This makes the temptation of dipping into it less prevalent and also the act harder to do. Usually bank to bank transfers take at least one business day and having that buffer will keep you in check. How much should you save in your emergency fund? You could choose Dave Ramsey’s $1,000 maximum in your "starter emergency fund." Or you could choose amounts that you decide to save in all your different emergency type sinking funds using Kelsa's approach.
For the full 3 to 6 months emergency fund, choosing the amount will be based on the likelihood of you relying on this money. For example, if you have a consistent salary from a W-2 job, having a minimum of 3 months would probably work for you. If you are a freelancer and sometimes have inconsistent income, maybe having 6 months would be better. Ultimately it depends on what you are comfortable with. Once you determine the number of months you would like to save, simply look at your monthly budget total and multiply it by the number of months you decide. That’s your goal for a fully funded emergency fund.
How do I start saving for my emergency fund? If you are using Dave Ramsey’s Baby Steps, after you pay off all your debt (Baby Step #2), you can move on to Baby Step #3 which is fully funding your emergency fund. If you are using Kelsa Dickey’s Plan Ahead Method, you would simply add your emergency sinking funds to your budget and fund these every month like your other monthly sinking funds. Set a goal for a set amount that you want to save every month. On top of that, if funding your emergency fund is your current financial goal, any extra leftover outside of your normal expense can be put toward your 3 to 6 emergency fund.
And that’s all you need to know about emergency funds! Until next time!