Understanding Your Emergency Fund
Understanding Your Emergency Fund
Of all the personal financial terms I hear people use, emergency fund is the one that seems to be most inconsistently applied when people are discussing their financial situations. While everyone seems to know they should have one, opinions about what it’s for, how to build it, and ultimately how much is enough to keep in it seem to vary widely.
What is an emergency fund for?
Almost all misconceptions about emergency funds are rooted in a highly variable definition of what constitutes an emergency.
One of the most common complaints I hear about trying to create a stable emergency savings fund is that it never accumulates because things—irregular, but not entirely unpredictable expenses—keep coming up that require the person or family to dip into their emergency fund. As a result, even though there may be a regular savings plan to get money into the emergency fund, it never grows to its optimal size.
Typically, this results from not having a plan to pay for irregular but relatively predictable expenses. Ideally, something like a new appliance for a house, a repair or maintenance bill on a vehicle, or an unexpected trip to urgent care or the vet wouldn’t rise to the level of emergency fund. As home or vehicle owners, parents, or pet owners, we can anticipate that these expenses will exist (even though we may not know exactly what they will cost or when they will come around).
Your emergency fund should be for the truly unforeseen – and often, the way you’ll know you’ve got the right mindset about an emergency fund is if you answer the question “what is this fund for?” with “hopefully nothing, ever,” because if you can see the potential expense on the horizon, that’s a cue to plan and save for it.
How to stop dipping into your emergency fund for non-emergencies
Of course, if you want to stop dipping into your emergency fund for irregular but not entirely unexpected expenses, you also need a plan to pay for those things. Otherwise, they will always rise to the level of borrowing from your emergency fund.
I think a three-part approach is often needed when trying to plan for non-routine but relatively predictable expenses:
First, plan your monthly budget (based on your historical spending) to include these expenses.
For example – if you review expenses from the previous year, and realize that you’ve spent $600 on vet bills, $900 on car maintenance and repair, $3500 on unexpected home-related maintenance and repair, and another $1000 on other necessary but irregular costs, a logical conclusion is that you probably need to budget an additional $6000 a year or $500 a month for these types of expenses. This is one of the reasons it’s so important to get a clear sense of your monthly cash flow.
Additionally – for those big-ticket items that are the eventual reality of something like owning a home or having a kid, it makes sense to portion off a separate savings bucket.
In the same way that you might use a college savings account to put away money for your kid’s schooling expenses that may be ten or fifteen years down the road, it’s a good idea to think about inevitable home ownership expenses – like a new roof, with a long-term plan in mind to save for them separately from routine or smaller home-related expenses.
Of course, with the way money ebbs and flows, that extra $500 a month in your budget may not be enough to cover higher expenses one month, or too much in months without a lot of extra expenses. So, you also need a way to flex a bit with the variability of expenses from month to month.
For this, you can utilize some sort of buffer savings account. This account is exactly what many have been utilizing their emergency fund for. It’s truly there to pull from as needed in more expensive months and build back up in less expensive months. Ideally, because you’ve also budgeted for those irregular expenses monthly, you shouldn’t be pulling from this all the time. In fact, in months where irregular expenses are lower than planned, it’s a good time to fill this account back up. This buffer lets you flex easily with the irregularity of monthly expenses, while not tapping into your emergency fund.
Continuing with the above example, if you budget $500 a month for irregular expenses, and have a buffer savings account that you try to maintain a $2000 balance in, when a month comes up that has a $600 vet bill and a $400 car repair bill, you’ll spend the $500 you’d already planned, then borrow the remaining $500 you need from the buffer account. Over the next few months, you may have fewer of these irregular expenses, so you’ll use the excess from that $500 you had planned to build the buffer account back up to your $2000 benchmark.
The benchmark dollar amount that you are aiming for in a buffer fund should be directly related to how many potential irregular expense-producing people, animals, or items make up your life. A homeowner with two cars, kids, and a dog is probably going to need more in their buffer account than someone without kids who rents a small apartment and uses public transportation.
How much should an emergency fund really have in it?
The most common recommendation for an emergency fund is 3-6 months’ worth of living expenses. The lower end of that recommendation is typically for folks who have a fair amount of income stability, and the higher end for folks whose income in more variable or more at risk.
Saving up this much takes time, and as mentioned in the previous section – it may need to move at a slower pace once you realistically start planning to budget for irregular expenses and fund a buffer account.
It’s okay to fund the true emergency savings a bit more slowly, provided you stick to your commitment to access it only during actual emergencies. However, you should have a goal in mind for where you want it to be eventually, and a plan to fund it regularly, even if it’s just a small monthly contribution.
The flip side, of course, is that if you truly hope to never access these funds, you don’t want to overfund your emergency account. Otherwise, you risk holding a lot of money in cash that could be better put towards different types of savings and investments. So once you’ve built the fund up to the desired amount, continuing to fund it slowly (or not at all) will likely give you the flexibility you need to start putting your money to work towards other financial goals.
What situations would trigger accessing the emergency fund.
Depending on your stage in life and savings-building, different things will trigger your need to access the emergency fund. Early on, as you learn to budget and build your buffer savings, you may still find yourself tapping into the emergency fund if an expense comes up that’s way outside of the norm that you haven’t had time to plan for.
But as you evolve financially, learning to better budget and prepare for life’s predictable expenses that show up at unpredictable times, ideally, the list of things that trigger you to tap into the emergency fund should grow smaller and smaller. In fact, if it’s an expense that you can name, and that is inevitable (like needing to replace a vehicle, a furnace or roof for your home), ideally you save for it before it happens, rather than counting on your emergency fund to bail you out.