If you talk to most grounded financial planners, they will talk with you about an "Emergency Fund" or some sort of savings that is earmarked for when things don't go according to plan. Some say that this is why you need good credit and high limits on your plastic, but if you are prepared, you can make it through most problems in life without getting stuck with a heavy debt burden on the way out. Following are some points that need to be considered when deciding if you should have an emergency fund and how much you should have if you do.
- What is an emergency fund for? - An emergency fund is to fund your life when something bad happens. It is not for buying a new car when your old one turns four. It is not for a pool, or even a new roof. An emergency fund is for when thing go bad. Examples are medical issues that come up and are outside of your ability to fund them in your budget. They are for when the car breaks down and you have to fix it to get it moving again. It is for when the house floods and you need a place to live till it gets dry and cleaned and for getting it dried and cleaned. These are all things that can not be planned for and can not be put off. If the roof is leaking, you can patch it up till you get the money together for a new roof, if you want a new car, save and buy a new car, your old one still works or you can make it still work till you can buy the new one.
- How much should you save? - An emergency fund is for paying for the issues above and there are several factors which deciding how much you need. What is your deductible on your health insurance? How about your maximum out of pocket? (Please have health insurance, another topic for later, but at least have disaster insurance.) What does it cost for you to live, the bare minimum? Now that you have figured it out, I would recommend having enough to cover your monthly expenses per month for every $10k you currently earn. That is to say, if you currently take home $50k, then save 5 months of living expenses. If you think you would be looking for an execptionally hard to find job, then add a few months to that. This should cover those other emergency cases, but if not add to it to cover them. There is a solid calculator here for calculating how much you need.
- Now to decide where to put the money - So there are only a few options here. You need to access that money without many strings in place, but you can usually get away with it taking a week or two to get to you. My conservative side would tell you to park it in a saving account that is either in a different bank or in a different account at your bank from the rest of your money. That way you are not tempted to steal from it to float your budget. If you talk to me when I'm not so conservative, I might give you different advice. You don't want to put it in something that could lose a lot of value, but you could get away with a CD if you could get a better rate. You could even step the CD into layers of bad. By this I mean, small emergency in one CD, difference to a major emergency into a different CD with a longer term and better rate, and then the job loss recovery into a third CD. If you feel confident in the market, you could put the last part of it in a conservative mix of investments, but if you do this, I would add 20% to what you calculated in the previous step. If you want to be even more creative, you could have this last third in 5 year old contributions from a Roth IRA and add funds to the Roth through either regular contributions which you did not previously plan on or would have been otherwise unable to contribute that year. The Roth is a great savings vehicle so I would be reluctant to ever take from it however, so that is only if you could not have contributed to the Roth otherwise. This assumes you have money in a Roth already. Never take from a 401k or IRA as you will be taxed at your current rate plus 10% penalty, and that just turns into a really expensive loan. Contributions more than 5 years old may be withdrawn without penalty.
The idea here is not to bullet proof your life, but to allow yourself a sufficient cushion for when the unplanned for happens. Life is unpredictable and this world is in a state of constant movement towards chaos, you need to set yourself up to weather the storm.
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