What You Need to Know: Emergency Savings

At some point in time, something will happen to us that we cannot predict. Something on the car breaks. The kids bust a window. Something.

Since we do not plan for these events in our budget, how do we pay for the expenses? The answer is emergency savings.

Why have emergency savings?

We all know that we will perish from Earth, but we do not know when or how. The same thing can be said about the rest of our lives.

  • When will you leave your job?
  • When will your car break down?
  • When will you break your arm?
  • When will your toilet overflow?

It is not a matter of if, but when. So we need to have something set aside for that future “rainy day.”

Why not use my credit card for emergencies?

Would you run to the bank and ask to borrow $1000 at 17%? If that sounds silly, consider what your credit card interest rate is. When using a credit card, you are borrowing money at a certain percentage.

Don’t a lot of families use credit cards for emergencies?

Oh, absolutely…and it’s unfortunate. This bad habit starts families on a terrible cycle of (1) having an emergency, (2) charging the credit card, (3) and paying off the credit card instead of saving. Then the next emergency happens, and the family starts the process over again. In order to break that cycle, we can start an emergency fund.

My savings account has low interest. Shouldn’t I invest the money instead?

Keep in mind that emergency money in a savings account (i.e., not a checking account) is also known as “Tiny Stuff Insurance.” The big problems in our life are already covered by other insurance; health insurance for cancer, auto insurance for car wrecks, and life insurance for a death in the family. Your emergency savings will cover the smaller things that the other insurance does not cover.

Give me an example.

Okay, let’s say you have a flat tire one day. Since you were not in an accident, car insurance won’t pay for it. Sure, some magical warranty might cover it, but let’s assume you do not have one. How are you going to pay for a new tire? This is where most families jump from one emergency to the next by charging a credit card and never putting extra money aside.

How much should I save in an emergency fund?

Your goal is to have 3-6 months of expenses.

Wait, which is it, 3 or 6 months?

You could look at it three ways.

  1. The first is: how quickly can you get a job if you suddenly lose yours? If you can find one quickly, maybe you only need three months of cash to live on. If you think it might take you a while to get a new job or you will need to relocate, make six months your goal.
  2. The second is: does your spouse also work? If one of you loses your job, it’s not as major of a problem, and you might consider saving only three months of expenses. Ideally, one of you losing your job means that the three months of savings could stretch for six months since only half the income is gone.
  3. The third is: what is the most expensive problem you will have that is not covered by insurance? This could be a new roof or your out-of-pocket maximum on health insurance. Which will cover that expensive problem, three or six months? That will be your goal.

Why not 12 months of emergency savings?

Because past six months of expenses, you are not being efficient with your money. You could use that extra cash to pay extra on the mortgage, save for college, or save for retirement. Owning your home or saving for retirement means that you will have assets that are growing at a better rate than cash in a bank. Some might also call this “opportunity cost.”

Alright, I am convinced. What is my next step?

Before starting to save your 3-6 months of expenses, be sure that these steps are done first:

  1. Start budgeting on a monthly basis
  2. Get $1,000 in emergency cash
  3. Pay off all debt (except the primary mortgage)
  4. Then save 3-6 months of emergency cash