An emergency fund is an important part of any financial plan and can be the difference between comfortably surviving an unexpected event and financial distress. A financial emergency can occur at any time and for a wide range of reasons. You may become sick or disabled preventing you from working, your home may need immediate repairs, or you may be laid off from your job. An emergency fund ensures you can still afford your necessary expenses without needing to dip into retirement savings or take on additional debt. From a financial planning perspective, your emergency fund is a top priority and should take precedence over any other short-term financial decisions.
The appropriate amount to put into an emergency fund varies greatly depending on an individual’s unique circumstances. Cost of living based on geographic location, owning a home versus renting, debt balances, and family size can all account for different emergency fund needs. However, the general rule of thumb is a minimum of 3 months of expected living expenses if you are a dual income household, and a minimum of 6 months for a single income household. In addition, add the amount of occasional expenses you expect to incur during the 3 or 6-month time period. For example, if you know you have to repair a car or make a home improvement.
When calculating your emergency fund needs, it is important to identify your discretionary and non-discretionary expenses. A budget can be extremely helpful in this area. Non-discretionary spending items are expenses you must pay every month, whereas discretionary spending items are luxuries that fall into the want category more than the need category. Non-discretionary items may include a mortgage, health and life insurance, car payments and insurance, home utility bills, food, and automobile gas. Adding your non-discretionary expenses together will tell you the minimum amount needed for each month. Multiply that amount by the number of months you need covered and you will have your total emergency fund savings need.
Your emergency fund should be kept in cash, or securities that can be quickly converted to cash, so the money is easily available. Stash it in a savings account or money market account separate from your everyday use accounts to help curb frivolous spending. Keeping the money separate can help you avoid the temptation to dip in.
If you want to try and earn a higher rate of return than the low interest rates being paid in a savings account, you can invest a small portion of the emergency fund balance in lower risk securities such as government or municipal bond ETFs and mutual funds. These are generally safer investments than equities, but be aware that they are not without risk. Avoid investments that could have premature withdrawal penalties like CDs. In general, use caution when investing your emergency fund and remember that this money has to be available in the event an emergency occurs, so playing it safe is usually the best decision.
An emergency fund should be regarded as a necessity, not a luxury, and is designed to protect you from unforeseeable financial circumstances. Without one you are living on the edge, and not in the positive sense. People who do not have some money set aside are just one event away from financial disaster. Protect yourself, protect your family, and protect your financial future by having an adequate emergency fund.
Jeff Witz, CFP® and David Zemon welcome readers’ questions. They can be reached at 800-883-8555 or at witz@mediqus.com or zemon@mediqus.com.
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