The Emergency Fund: What it is and why you need it

Emergencies – never fun events to plan for!

Everyone knows emergencies of some sort MIGHT happen, but thinking about them is a little depressing, don’t you think?

But I will tell you this: the smartest people in the room are the ones who plan for financial emergencies.

I’m going to explain to you the purpose, the components and the benefits of the emergency fund.

The title doesn’t hide the purpose.

An emergency fund, also called the "emergency cash fund" by some financial planners, is a rainy day fund to cover all your unknown expenses that always seem to hit at the wrong time.

Ideally, your emergency fund would be enough to pay for at LEAST six months of your living expenses. Cash should be your first line of defense against any emergency expenses – if you use a credit card, you’ll run the risk of incurring interest payments which will dig you into a deeper financial hole. 

Give yourself TIME to stash away the necessary amount. Personally, I was able to accumulate an emergency fund by taking a certain, pre-calculated amount from each paycheck, and depositing it into a certain interest-bearing savings account. Using a CD for such a fund is not recommended because you’re going to want to have complete access to it without incurring any penalty fees for withdrawing before the CD maturity date.

Also, timing is really important: you should concentrate on building an emergency fund when you have you credit cards, mortgage payments, or in my case, student loans under control. This is probably not a feasible financial step if you don’t yet have enough to live on, or you’re not done paying down your highest interest credit cards or debt. This should be a medium-term goal (1-5 years) to help you achieve a little financial security.

Benefits:

Let’s say you are laid off from your job – a situation not unlikely in today’s economic landscape. Your emergency fund can be used to keep you afloat by covering rent or your home mortgage. Let’s say you get into a car accident; your emergency fund can be used to pay your deductible in such an instance.

In my case, I left my job. However, I overestimated the amount of money I would need to keep me afloat during my time of unemployment. But with my emergency fund, I didn’t have to completely cut out eating out at restaurants because I planned for it in advance and stashed it away in the emergency fund.

Other benefits include: financial peace of mind and a greater net worth. You can sleep well without worrying that if unexpected, large expenses presented themselves, you would be able to pay for them.

You accumulate greater net worth because if you build up savings, and have more cash set aside, this lowers the ratio of debt to equity and makes you look like a champ if you ever need to borrow from a bank or other lending institution.

In action: 

Put away $100 per month at 2% interest and in 3 years, you’ll have $3,700; in 7 years you’ll have over $9,000!

Put away $200 per month at 2% interest and in 3 years, you’ll have $7,400; in 7 years you’ll have $18,000!

Put away $250 per month at 2% interest and in 3 years you’ll have $9,200 and in 7 years, you’ll have $23,000!

Just a little bit each month in an interest bearing account and you’ll enjoy a bit of calm when unexpected expenses present themselves.