Money can't solve all of your problems, but it can make minor disasters easier to get through. If you can't eliminate bad luck altogether, the next best thing is to come out relatively unscathed and debt-free. Need an emergency car repair so you can keep going to work and earning income? Lost your job and need cash to pay the rent? That's what an emergency fund is for.
Why Keep Emergency Cash?
By keeping a cash reserve that's easily accessible, you protect yourself from life’s unknowns. You’ve got a safety net just in case something expensive happens. You might lose your job, incur medical expenses, or have other accounts frozen in error. If any of these things should happen, you’d need money fast. Your emergency cash is there for you.
If you don’t have emergency cash, one setback can create a multitude of problems. You might have to borrow money at unfavorable terms or skip important payments. Then, you’d have a debt burden or a dinged up credit score in addition to the original problem. What's more, you’ll have flexibility, the ability to fix things quickly, and more choices if you’ve got cash on hand. Most importantly, you'll have peace of mind.
Where to put It
Emergency cash needs to be liquid. This means that it’s easily accessible – without cost, delay, risk, or penalty. The best places for an emergency fund are savings accounts and money market accounts. A ladder of short term CD’s might also work, but you’d end up paying penalties if you have to cash out early.
Online bank accounts are a great place to keep your emergency fund. They pay competitive interest rates, and some offer "no penalty" CDs that pay even more. You can transfer money from your online account to a brick-and-mortar bank in a few business days, and most even offer checkbooks and/or debit cards so that you can make a payment instantly. For more ideas, read about why you should bank online.
Too Much of a Good Thing?
Liquidity comes at a cost. The easier it is to get your money, the less you earn on it. As a result, you need to manage your emergency cash. Keep enough on hand – but not too much. If your emergency cash fund grows too big, move some of that money elsewhere for longer-term goals.
Some argue that emergency funds are to be avoided because FDIC insured bank accounts pay very little; some people do just fine without emergency savings. If you have other liquid assets available (and you don't need those assets for other goals, such as retirement or a home purchase), you might not need to set up a separate emergency fund that's funded with cash. The important thing is to have a pool of money to draw from when something happens. Keep in mind that investments may lose value at the same time that you lose your job (remember 2008?), so plan accordingly.
How Much Emergency Cash Should You Stash?
Evaluate your expenses and your risks to figure out how much your emergency fund should have in it. A rule of thumb to start with is somewhere between three and nine months’ worth of living expenses. It really depends on how stable things are for you and how secure you want to feel. If you feel very secure (like you won’t lose your job anytime soon, you have great insurance coverage, and you have good luck in general), then you may want to be near the lower end of that range.
If saving several months’ worth of expenses is not a possibility for you, try building an emergency fund of $1000 or so – just in case.
What's an "Emergency"?
If you look at your monthly budget, you probably have a wide variety of expenses. The important ones for your emergency cash fund are your basic fixed expenses: mortgage, rent, insurance premiums, transportation, food, etc. You don’t need to include the amount you save for your future each month – since you probably won’t save in an emergency anyway (you’ll have bigger fish to fry if you lose your job or suddenly face huge medical expenses). Just keep enough stashed away to provide for your basic needs and avoid taking on debt.
After You Spend It
After you use your emergency cash, you’ll need to rebuild the emergency fund as quickly as possible. Remember how nice it was to have some funds on hand, and start on the task of rebuilding those funds. You never know when the next crisis will come up.
Remember, no cheating – don’t use the emergency cash for non-emergencies (like TVs, home improvements, or vacations). You should have separate savings account for those other goals.