Update: This post continues to be a very successful post and I have updated it for 2014.
This is a two part post covering the following topics.
- What is an emergency fund?
- Why do I need an emergency fund?
- How much do I need to save?
- How to get started?
- How to invest your emergency fund?
- What are the common pitfalls of emergency fund and how to avoid them?
What is an emergency fund?
An emergency fund is the money you set aside to use when life presents you with unfortunate and unexpected events.
Simply put, emergency fund is the money you save in an easily accessible account so that it can be used to cover up for some expenses which you did not foresee or budget for; like a breakdown of your heating system, major home or car repairs or more unfortunate circumstances like job loss, major medical expenses, disability, accidents, etc.
Why do I need an emergency fund?
While I hope none of these events happens to you but none the less if you do make an emergency fund you will be in a better financial position to handle such an event. Many people seem to underestimate the chance of them having to face such a situation, especially young people, so if you are one of them, think again; Ask yourself, do I have enough saved up to cover for my expenses for some months in case of an emergency?
There are some psychological advantages to know that you have your back covered in unfortunate times, this will really help you live in a better way by relieving some of your stress.
It is very important, considering the critical nature of these funds I would recommended building an emergency fund over any kind of debt (even credit card debt, you heard me right…!).
How much do I need to save?
Unfortunately there is no magic number here but these guidelines should help you come up with your own number.
- Calculate your regular expenses. Your regular expenses should include things that you generally spend on, on a regular basis. You could take an elaborate way to fund this out (like the one described here) but a back of the napkin approach works well too. Just add up the following:
- Your monthly mortgage payments/rent and car loan payments.
- Your monthly cost of insurance.
- Monthly cost of essentials (groceries and travel).
- Monthly miscellaneous expenses, like entertainment, shopping, etc. Your credit card (or debit card) statement should come in handy here.
- On average you should save enough to cover up for about three to six months of regular expenses. This should help you in cases like job loss or a temporary disability.
- You regular expenses will be higher if you have dependents that you support.
- In general you will need more in emergency funds if you have more responsibilities and obligation to take care off. Just be sure to include all such expenses and then add a reasonable buffer on top of that.
- Also make a list of expenses that you could quickly get rid off in an event like a layoff, say if you are an iPhone user, you could drop the data plan, or get rid of the extra channels in your cable connection. This might just come in handy. You do not have to write it down; just keep it in your mind. In general the more expenses you can cut down in case of a financial emergency the lesser you will need in emergency funds.
Part 2 here.