It tends to be last on the list of financial priorities, but an emergency fund — money set aside for unexpected expenses such as medical costs, surprise home or car repairs, travel, or job loss — can considerably improve your overall financial situation.
The amount needed in an emergency fund varies from person to person and depends on the situation, but a general rule of thumb is that the fund should equal three to six months of expenses. Variables that could affect the needed amount could include having a spouse who does not work, having a seasonal job, or having a very conservative or aggressive risk tolerance.
Why is an emergency fund so important? Because having one ensures that you can pay for unexpected costs without turning to sources of funds that lead to harmful financial outcomes.
Few good options
Not having an emergency fund doesn’t mean you can’t pay for emergencies, but it does mean that money will have to come from somewhere — usually a place that you’d be better off not touching. Here are some of the typical sources of funding people tap when they lack an emergency fund:
Retirement savings: Let’s say you had to withdraw $12,000 today from a retirement fund for an emergency. In 30 years, that same $12,000 would have been worth almost $52,000, assuming a modest 5% return and not making any adjustments for inflation. That’s money you won’t have when you retire, and it’s because you didn’t have a sufficient emergency reserve. Depending on the situation and retirement account, you also may have to pay penalties and taxes on the amount you withdraw.
Credit cards: Simply put, interest rates on credit cards are high. Taking on the extra debt can affect your credit score, and if you’re already in a sensitive financial situation, using credit cards can lead to potential late fees or worse.
Family or friends: It can be a big mistake to depend on anyone else to bail you out of a financial hardship. That person might not be able to help, or it might place stress on the relationship.
As you can see, these aren’t great options for paying for emergencies. Building an emergency fund is clearly preferable.
Benefits of having an emergency fund
Spending control: Keep your emergency fund in a separate account and away from your day-to-day sources of funding. When you don’t have easy access to your emergency fund via debit cards or other means, you decrease the chances that you’ll dip into the account. You also can easily determine whether you need to save more or whether you have reached your funding goal by having a separate, stand-alone balance.
Peace of mind: There’s nothing exciting about carrying a spare tire in your trunk, and there’s nothing fun about changing one. But you’re thankful it’s there when you really need it. This same logic applies to having an emergency fund. It gives you protection from unplanned financial events that often are main causes of stress.
Having an adequate emergency fund is as important as building your house on solid ground. By maintaining such a fund, unforeseen costs can be quickly absorbed without compounding the problem by adding debt to the equation. Creating an emergency fund is one of the biggest components to having financial peace of mind and increasing your chances of reaching your long-term financial goals.