Dec 2nd, 2007
Call 911!
An emergency fund is, well, a fund (a pool of money) that is used in the event of an emergency (such as a loss of a job). Every book I’ve read on personal finance discusses the importance of an emergency fund; what they differ on is how much, where to keep it, and at what point to put money into it.
Dilbert’s one page book on personal finance, which is one of the best pieces ever on the subject, discusses the emergency fund in a single sentence:
Put six months worth of expenses in a money-market account
This is an excellent starting point. Six months is a considerable amount of time; if an emergency of some kind happened, like the loss of a job or a serious illness in the family, it’s likely that six months would be long enough to resolve the situation. A money market account is a safe, easily accessible place to put money that pays better interest than a typical savings account.
Is six months really the correct amount? It’s difficult to say. Those who are currently strapped for cash (those, say, in credit card debt) may not feel they can afford to put six months worth of expenses into an emergency fund paying 5% when they have 20% interest rates breathing down their necks. Even those without debt who are saving for other goals may feel like six months is excessive when they’re trying to save for their kid’s college fund or the down payment on a house. Some people will settle for a smaller amount (say three months), or sometimes a relatively small dollar amount (say, $1000). Others may use “case equivalents”–for example, I try to keep a minimum balance of four weeks of vacation time on the books at my job; I think of that as a month’s worth of salary for emergencies. Others may gamble and say that their credit cards are their emergency fund; it’s a dangerous gamble, but the argument is that if there really is an emergency, they’d have to spend whatever that had saved anyway, so the interest doesn’t mean all that much.
Where to keep the fund? If the emergency fund is really in cash, a check writing money market account is an excellent place to keep it; I keep mine in a Capital One Direct account and I have a checkbook to use if I need to. Others may wish to use a credit or bank local to them so they can go into a branch if they need assistance. Some may opt for certificates of deposit for at least part of their emergency fund to try get slightly higher interest and a locked in interest rate. While this is fine for at least some of your fund, I would suggest against having your entire fund in there, as you’ll either pay a significant penalty to get your money out or you’ll have to wait until the CD matures. Considering the rather slim differences in interest rates between CDs and money markets, I’d stick with the money markets.
When in your overall financial plan do you establish your emergency fund? It’s hard to say; a purist would say this is the first thing you do. Someone who is battling considerable debt and looking at interest rates would likely say that it gets done after paying off that high interest debt. For me, I’d say to split the difference; start by trying to put away at least a minimal amount (say, instead of six months, a single paycheck), then go ahead and attack your debt. If you come into a windfall (say a large gift or inheritance or a bonus at work), use that to build your fund (or at least split the total between the fund and paying off debt). When your unsecured debt is totally gone, consider building your fund to at least three months if not the whole six months.
And remember that an emergency fund is really meant for an emergency! A new model of iPod is not an emergency, and neither is a dress you look great in. On the other hand, an automobile repair or a serious illness is an emergency; in those kinds of cases, don’t feel any guilt about dipping into your emergency fund.
