What is an Emergency Fund?
If you don't already have an emergency fund, it's probably a good idea to get one. But what is an emergency fund?
It's a sum of money that is either already liquid or can be easily liquidated in case of an emergency. That's it in a nut shell, but it doesn't really tell the whole story or help you to figure out what, how much, and where you should be saving.
How much should be in my Emergency Fund?
Most resources insist on a six month emergency fund, meaning that it has enough money in it to sustain you for six months of living; mortgage, car payments, insurances and general expenses such as groceries and gas. But really, to assess how much you need for an emergency fund you need to assess your lifestyle and work situation.
Questions like, 'how reliable is your job?' If you had to leave it suddenly for any reason, how long would you expect it to take to get a job with a similar level of compensation? If you work in a high-demand field and have a stable position, a three-month emergency fund would probably suffice. For anyone working in a contract-based environment with an uncertain future, aiming for a more substantial, nine-to-twelve month emergency fund would probably be wise.
What is an Emergency Fund used for?
An emergency! Plain and simple. Unexpected medical bill? Emergency fund. Sudden loss of job? Emergency fund. New Xbox? Probably not. Most recently, I knew of someone who was able to easily pay for a major surgery for their dog from their emergency fund, which is something that would have resulted in some painful decision-making had they not been prepared.
What comes first, Emergency Fund or Retirement?
This is a very common question and it can often seems as if there is an endless amount of 'pots' your need to put money into: 401(k), Roth IRA, regular IRA, your kid's college fund, and now an emergency fund too.
What should come first? The thing about an emergency fund is that the cash is readily available for whenever you need it, unlike most forms of retirement savings. If you face unexpected expenses and need to dip into your 401K or IRA you can face huge penalties which, as we know, is a terrible way to spend, or rather lose, money. Having a well stocked emergency fund protects your other savings from this type of hit. So, it's important to prioritize this, at least for a short time, while you build up your fund.
How and Where to Save an Emergency Fund
The key to a successful emergency fund is to have it close-to-hand, but not too close-to-hand. For some people, holding it in their checking account suffices, but for others the temptation to spend it is just too much. You may prefer to hold it in a savings account or even at a separate online bank, so you can't just go into the branch and withdraw funds when you fancy a nice dinner out or weekend away.
Saving in CD's is also an option, although you need to remember that the funds need to be able to be liquidated in a timely fashion. If you save in a CD, it might be worth keeping enough money in your regular checking or savings account to get you through the holding period.
It would be wise to factor in saving for your emergency fund in your monthly budget. If you take the money out as a priority and work on not touching it, before you know it you will be well on your way to to ultimate preparedness.