Basic, Boring, Best?
Today I'd like to talk about emergency funds. What are they? How much money should you have in one? Who needs one? And what should you use them for?
If you already have an emergency fund and know exactly what circumstances you will use it in feel free to skip this post or just read along nodding your head and smiling smugly ;)
What is an emergency fund?
An emergency fund is a form of self-insurance. It is money that you save up so that you can use it in emergencies, when you need money unexpectedly.
If you have an emergency fund you won't need to borrow money for sudden expenses nor be forced to sell things you didn't want to sell.
The most important aspect of an emergency fund is that the money must be safe and accessible, so most emergency funds are held in instant-access bank accounts.
Your emergency fund should not be in something that experiences price changes nor somewhere where you can't access it immediately.
Who needs an emergency fund?
Most people should have access to enough cash to meet their needs. Emergency funds are more important the more responsibilities you have and the less stable your sources of income are.
If you are single with no dependents and no debt, and you have a stable job and adequate health insurance, you probably don't need a large emergency fund.
If you have children and others depending on you financially, if you are working on short-term contracts or don't have health insurance, you will need a much larger emergency fund.
How much money should be in an emergency fund?
This depends on your circumstances. People generally think about emergency funds in terms of a number of months of living expenses. Living expenses would be what you need to survive in an emergency: things like rent, food, insurance, etc.
Three months might be a minimal emergency fund, and eighteen would be a very conservative one.
What should you use your emergency fund for?
Emergency funds are there to help you with large unexpected expenses. Replacing a car, fixing a boiler, paying your rent and food bills while you look for a new job are all examples of situations you'll be glad you have an emergency fund.
You shouldn't be paying for everyday spending or anticipated expenses like holidays with your emergency fund.
If you are comfortable investing an emergency fund can also act as 'dry powder' for you to use to buy shares during a market crash.
What other considerations are there?
The main thing to think about with regards to emergency funds is opportunity cost. What else could you be doing with the money? Most emergency funds won't be earning much interest or gaining in value, so you don't want to have much more money than you need in there.
Another thing is that a high saving rate is a form of emergency fund. If you are used to saving 50% of your take-home pay, that gives you a lot of leeway month to month. If you have a large unanticipated expense you might be able to cover it by not saving as much that month.
The nice thing about saving for emergency funds is that it gets you into the habit of saving. If you start putting away 10 or 15% of your monthly pay to build up a fund, you get used to a slightly less spendy lifestyle. Once your emergency fund is big enough you can then switch the monthly saving into investing instead. It's a relatively painless way to build better financial habits.
Personally I am only just building up my emergency fund. I save 20% of my monthly paycheck into a British pound denominated account with Shinsei Bank. I currently have a couple of months' living expenses in there and am aiming to build up about a year's worth. Because my work situation is fairly stable and I don't have many financial responsibilities I am investing and saving at the same time.
How about you? Do you have an emergency fund? How big is it?