Get a small emergency fund

You need an emergency fund.  I personally don’t think that is up for debate in the personal finance world. The amount in your emergency fund and where you keep it certainly is though.  At this stage in your personal finance adventure, you need at least $1,000 in your emergency fund.  Do you realistically need more than that? Of course.  We’ll get there soon but for right now you need at least $1,000 or at least one month worth of your typical expenses.

Get a small emergency fund

Wait… I want to start at the beginning.
Link to the previous step – Step 4: Budgeting

Your Small Emergency Fund

Do you already have an small emergency fund with at least $1,000 or one month worth of expenses?

• Yes: Perfect, keep going
• No: Don’t worry, we’ll work on building one below

Do you have at least that amount saved away in a separate account for emergencies only? If you do, that is great and we can move on to the next step toward financial independence. If not, that is perfectly fine since you are starting one right now.  Keep saving every extra dollar at the end of each month until your emergency fund has at least this small buffer amount.

Worry about the emergency, not paying for it

Even that small amount can help reduce the stress of an emergency and keep you from financially spiraling downward when one domino gets kicked over.  Once, years ago, we left the house for a weekend stay at Disney World for some rest and relaxation.  The stay was so obviously fun and we arrived home to what we assumed was the usual laundry and chores to prepare for the upcoming work week. 

Unfortunately our water pipes decided to take the weekend off as well. They leaked a steady stream of water in the wall of our master bedroom all weekend.  Thankfully it wasn’t a huge leak. But the hot water heater, the water pipe in the wall, and the wall itself needed to be repaired as soon as possible so that we could restore water service to the house.

Knowing we had money set aside in our emergency fund for exactly this type of situation helps reduce some of the stress while dealing with the aftermath. We didn’t need to work out how we would come up with the money to get the pipe fixed. We already had it and could focus on getting everything back to normal.  At this stage in the journey to financial independence even a small unexpected expense can derail your monthly budget. Unfortunately this can cause many people to just give up thinking everything is too out of their control.  The small emergency fund gives you back some of that control and provides a psychological safety net.

Wait… let’s define an emergency

Before we get into a discussion of the mechanics of an emergency fund, I think it is important to lay out what exactly a financial emergency is and what is not.

A financial emergency is any unexpected expense that needs to be paid within the next 30 days that was unforeseen or sudden in your life. A medical emergency requiring immediate treatment is a good example such as a broken bone or allergic reaction to food.  Car repairs that are not related to regular wear and tear on a vehicle are often budget killers.  Fixing something on your car that should have been properly maintained on a schedule though is not an emergency.  Oil changes, new tires, and brake replacements are all mostly known expenses that can and should be planned for financially. 

Similarly, some home repairs are emergency expenses like a water leak or appliance breakdown. Regular maintenance items are certainly not when ignored to failure. Too often, people will ignore maintenance in the hopes that they will go away on their own. They hope to avoid spending that money but usually create more. Many times the ‘emergency’ fix costs a lot more than the cost of maintenance.

Good examples

Veterinary expenses for a sick pet are hardly ever planned-for expenses.  Family emergencies like an illness or funeral, requiring you to travel without advance warning can be considered a financial emergency.  Finally, job loss or reduction in work is usually not something we can plan for ahead of time. This reality was illustrated quite starkly by the COVID-19 pandemic.  Many seemingly stable jobs were put on furlough almost overnight and the hours significantly cut or eliminated. The service industry being a prime example of such a dramatic shift.

The examples above are all good reasons to have an emergency fund.  A fund from which you can pull money to pay for these unexpected events without resorting to debt through a line of credit or credit card.  It is empowering in those situations where you often feel powerless. Knowing that you already planned for this eventuality (because it *will* happen eventually) and have a solution.

Bad examples

That said, there are a lot of bad (less good?) reasons to dip into your emergency fund that are used far too often by far too many people.  They mean well I imagine and might have truly convinced themselves that they are pulling the money out for an “emergency” when it might just be a want instead of a need.  That could be wishful thinking on my behalf to assume they aren’t sabotaging themselves and it is really just poor planning on their part.

A financial emergency is not something that you currently want but don’t need.  It isn’t something that you could have realistically saved for but chose not to. Wanting something now instead of later isn’t an emergency. The expense isn’t something that could legitimately be postponed for another date down the road.  It isn’t for vacations.  It isn’t for something that went on sale today that you don’t immediately need but are totally getting an amazing deal on it so it is obviously saving money to buy it now.  All of those situations are expenses that you are more than welcome to save up for and participate in. But you need to be under no illusion that they were financial emergencies.

Know the difference

The ability to separate out true financial emergencies from reckless spending habits is a skill one acquires over time through practice and repetition. You’ll make some mistakes in the beginning and justify the expense. You’ll be convinced by family and friends that spending that money was the right thing to do at the time but reflection later will correct that. It is ok as long as you learn from the experience and do better next time.  All we can do is the next right thing.

Stay out of your emergency fund

What we don’t want to do with an emergency fund is to constantly draw down the account and be forced to replenish it, potentially leaving us with a lack of money in a true emergency.  We also want to make sure that it is liquid cash you can access within a couple days at the most.  A line of credit or credit card isn’t a true emergency fund and relying on those will only cause further headaches as repaying those in an emergency will be much harder than simply replenishing a savings account because you have to pay the amount back with interest.

This is a discussion for much further down the path but having these funds available as cash or cash-equivalent is important instead of temporarily investing this money.  Without going into the arguments involving the cash-drag of a savings account, it is best to keep your investments separate from your emergency fund.

Set it & forget it. ~Ronco Rotisseries & emergency funds

What we do want to do with our emergency fund is make sure we are always maintaining the determined balance and leaving it alone.  That amount might be $1,000 now but will need to be bumped up to at least 3 to 6 months worth of your current monthly expenses.  That figure will depend on the relative stability of your job, industry, and employer (something the 2020 pandemic showed could be in question for even stalwart companies in established industries). 

The more stable those components of your income are, the less you could potentially save in there for emergencies but it is better to err on the side of caution especially in the beginning of this journey.  Also, you need to factor your personal risk tolerance into the equation: maybe you are particularly risk-averse or grew up in a financially insecure household and personally feel like you can sleep better at night with 12 months of expenses saved up.  Adjust accordingly.

“Gotta keep em separated” ~Offspring (CFP?)

I’m assuming that catchy 1994 Offspring song “Come Out and Play” was about emergency funds, don’t ruin it for me. As noted above the money should be saved in a separate account, preferably in a high yield savings account.  These types of accounts are available at every major financial institution though the interest rates will vary wildly.  Online banks tend to offer the higher rates while larger, national banking brands tend to be on the lower end of that scale. 

I personally think your emergency fund should be at a separate banking partner entirely from your everyday transaction accounts like your checking and savings.  Not only will you get a slightly higher interest rate on the emergency savings, but transferring the money back to your checking account will take between 1-3 days to process.  This might sound like a bad thing initially but I honestly believe that a built-in buffer of a couple days will really make you second-guess that expense both in terms of the time to think about it and the extra steps involved.

You really start questioning the importance of that expense when you have to log into a different bank and initiate a balance transfer and the extra three days to think about it might make the difference between a reckless purchase and a good choice for your financial future.  In a true financial emergency, the couple extra processing days will likely not matter.

Emergency fund =/= Splurge savings account

One extra note on using a special savings account for one-time expenses not related to your regular monthly budget.  The concept is called a Sinking fund and it is decidedly different from an emergency savings fund. A sinking fund is saved money for a specified purpose like a vacation, christmas gifts, annual dues.  These are funds we are saving that we will spend within a year or so that IS NOT your emergency fund.  This buffer helps you not draw into your emergency fund and leave you in a lurch during an actual emergency.  Please set these up for your future one-off expense planning and leave your emergency fund for true financial emergencies.  Your future self will thank you.

Note: Amount is up for debate

Big Ern of Early Retirement Now has famously had no emergency fund. You can read the article here where he explains his logic behind the controversial idea here at his website. As a financial analyst and logical person, I can see how that math works out (even in a black swan event like COVID 19). That said, it is hard to get past the psychological comfort of having that money set aside for emergencies even though I still have access to it in the investments.

TL;DR

You need an emergency fund.  You need at least $1,000 in it right now but more soon. Don’t touch it unless it is a legitimate financial emergency you could not have planned for and absolutely need it.

Link to the next step – Pay all bills on time