Do I need an Emergency Fund?

Do you need an emergency fund?

I previously wrote about how to make more money from your emergency fund, but I decided to take a step back and explain the purpose for an emergency fund. I used to think of an emergency fund as robbing myself. It was essentially the same as paying taxes in my mind. All I knew was that money was coming out of my pocket going somewhere else. Obviously, this was completely untrue, but it was how I felt at the time. Thankfully, I learned how beneficial an emergency fund is to my long-term financial well being.

If you had a $500 unexpected expense come up right now, how would you pay for it?

If you could come up with the money and NOT have to use a credit card, you are doing much better than most Americans. Life happens, and unexpected expenses are to be EXPECTED. If you prepare for them you will be able to better avoid a financial crisis, if not, that is what they call “learning the hard way.” Lets say (for sake of discussion) that emergencies happen, on average, once every year (everyone’s definition “emergency” is different, so the frequency may be more or less for you) and cost an average of $500. The truth is that just about everyone does have an emergency fund. The only difference is that they are either earning interest or paying interest.

Paying Interest

Let’s look at the typical American response to an emergency (costing our assumed average of $500). Emergency #1 happens and they don’t have an emergency fund, so they borrow the $500 from a credit card (17.5%). This solves the short term problem of paying for the emergency, but now they have to start making payments to the credit card company. Things are tough enough, they didn’t have the money to pay for Emergency #1 to begin with, now they have to try to find $20 each month to pay the minimum payment and to add insult to your injury the credit card company is going to charge them a huge percentage rate on the amount borrowed. When emergency #2 happens they will likely be:

1. Still trying to pay for Emergency #1 (they will still owe $350)
2. They will still be paying the interest to the credit card for Emergency #1
3. It is probable that they were not able to save up for emergency #2, since they were still spending extra money to pay for emergency #1, therefore they will have to borrow again to pay for Emergency #2
4. Now they are paying back both Emergency #1 and #2 ($850 total), paying interest on both amounts borrowed, and in even a more difficult place to start saving for emergency #3 since their minimum payment increased to $35.

This is only the beginning of the vicious cycle: it only gets worse from here. You can imagine what their financial lives will look like in 5 or 10 years.

The prudent see danger and take refuge, but the simple keep going and suffer for it. -Proverbs 27:12 (NIV)

Earning Interest

Let’s assume you are one of the few (but extremely wise) Americans who decided to start an emergency fund (because some equally wise blogger told you it was a good idea). If you were able to find that $50 a month now (before emergency #1 happens) and start saving it to prepare for it, you would likely (and hopefully) be here when emergency #1 happened:

1. Have more than enough money saved for emergency #1 ($600 saved)
2. Will have earned interest ($15) on your savings which will have just increased the size of your savings even more ($615)
3. You will have a head-start saving for emergency #2, because you saved more than enough for emergency #1 ($615-$500=$115)
4. You will be earning interest on what you still have saved after paying for emergency #1 ($115), and you will be saving and earning interest on the amount you are saving for emergency #2.

When emergency #2 rolls around you will have $735 saved up to pay for the $500 emergency. Just repeat the process again and again and you can imagine what this will look like after 5 or 10 years.

How much should I put in my emergency fund?

I think $50 a month is a good ballpark to get started for many people. Obviously if you are making six figures, you may want to increase the amount or if you are making four figures, that may be too much. If you are having trouble finding the extra money, you may need to quit spending everything you make or learn what to do with a raise.

Where do I start an emergency fund?

I recommend ING Direct for a high yielding savings account. The most important part is getting started, no matter where it is. But, look for something that you can direct deposit into so you do NOT have to think about it.

Before I get a bunch of comments arguing about the frequency of emergencies or how much the average emergency costs, let me just say these assumptions are based on how things have worked out for me. I am sure some will have “emergencies” every 6 months and some every 4 years, but I am basing this off averages in my life. My intention is only to show the long-term benefit of building an emergency fund rather than using a credit card.