I’m not sure if anyone else has noticed this, but the world is cray-zee! Thankfully, there’s this really important personal finance principle called an emergency fund, which I’ll talk about over the course of a 4 part series.
I live in the real world, and so do you. Work can be insane, babies (of the human or canine variety) can wake us up in the middle of the night, kids get sick, and cars break (almost always right before a really important meeting). The real world guarantees plenty of stress, but hopefully, a good emergency fund can help you sleep just a little more soundly at night.
So, what is an emergency fund? This is money set aside for unforeseen expenses. It should be easily accessible so that you don’t have to threaten the financial stability of yourself or your family by accumulating high interest debt (i.e. from a credit card or payday loan) during difficult times.
4 big takeaways:
- Why do I need an emergency fund?
- Where do I put my emergency fund?
- How much do I need in my emergency fund?
- When can I use my emergency fund?
Over the next 2 weeks, I’ll cover each of these topics in detail, ensuring that you have the tools necessary to establish a buffer between you and the craziness of this world we live in.
Why do I Need an Emergency Fund?
Honestly, because life happens.
Let’s think about this for a second. Everything’s going great until…
- You get laid off and don’t have a paycheck anymore
- You work on commission, and tough economic times cause your pay to dramatically decrease as sale numbers drop
- You or someone in your family has a medical emergency
- Your car breaks down
- You live in Minnesota, and the heating system in your home breaks… and it’s December… and all the relatives are in town for Christmas
- Or maybe you live in Texas, and the AC breaks… and it’s July
Scenario: You have to pay to fly your family of 6 from California to Massachusetts, stay in a hotel for a week, and then fly back because a loved one suddenly passes away. The trip could easily cost more than $5,000. First off, you don’t want to miss something like a relative’s funeral because you’re worried about finances. Second, if you do go, you don’t want to obliterate you and your family’s financial future for one event.
Are we on the same page yet? Life happens, and when it does, sometimes the results aren’t pretty. But why, you ask, do you need to set aside a specific fund for this? Good question!
Assume an emergency does come up. You don’t have much cash sitting around, but you have a credit card with a high limit due to the good credit score you’ve been working towards, so you use the card to cover the expense.
Unless you’re rolling in dough, it could take a while to cover all of your regular expenses and pay off a $5,000 bill. In the meantime, you’re covering the exorbitant 15% interest rates. If you just don’t have enough cash flow to cover payments, or if other surprise expenses come up, then you have to watch as the snowball effect takes over. Suddenly, the great credit score you worked so hard for wastes away in a matter of months as you can’t make payments on time.
If you didn’t have good credit score to start with, then you probably don’t have a high enough limit to cover a major expense with a credit card. When I opened my first credit card to take advantage of the cash back rewards, the limit was only $2,000. If you don’t have any other way to cover the emergency bill, then you’re really in trouble.
You may be thinking: “I don’t even need to use a credit card. I have other assets set aside.”
Let me tell you why that approach won’t necessarily work.
You may think you can handle a financial setback because of money in an IRA or 401k. If you are setting aside for retirement, then that’s great! But, you don’t want to rob from your future any time a big expense comes up. I’ll discuss the special benefits of retirement accounts in the future, but for now, know that by law, those accounts have annual contribution limits.
If you withdraw from an IRA or 401k, then you can’t necessarily put extra money back in later. Those accounts provide tremendous long-term advantages, so you don’t want to make a withdrawal unless absolutely necessary.
What about stocks and bond funds in a regular investment account? Generally, you can sell those assets quickly, but the timing could be terrible. Markets fluctuate. As a matter of fact, the US stock market has lost half its value twice in the last 15 years. Even bonds, which are generally less volatile, have the risk of losing value over the short term. When the price of your investments is low, you don’t want to have to sell them and lock in a huge loss.
Other investments, such as land or rental houses, are extremely illiquid (hard to sell quickly), and you never want to be in a position where you have to sell real estate to cover expenses.
This is why you need an emergency fund. Life happens… surprise expenses will come up. But, when they do, you don’t want to be stuck paying with a credit card, dipping into a retirement account, or selling assets at the wrong time. Thankfully, there are a couple places to store money that will allow you to sleep soundly at night. What are those places? Don’t forget to check back in on Thursday to find out in Emergency Fund Part 2!
Has there been a time in your life where you wished that you had an emergency fund prepared? Leave a comment below and start a conversation!