Emergency fund is a sum of money set aside to deal with any unexpected personal or financial emergencies such as losing a job, medical emergency, home repair, car trouble, etc. The funds should be readily available if a need arise and should be kept in a safe place such as in a bank or credit union.
How much should you have in an Emergency Fund?
Most financial advisers recommend at least 6 months of emergency fund to cover any unexpected expenses; however, the amount can significantly vary depending on your monthly expenses and personal situation.
Here are some of the questions to ask yourself when determining emergency fund amount:
- What is the biggest unexpected expense I can incur? For some people it may be the replacement of their house's roof, for others it could be having to pay medical bills including deductible and out-of-pocket cost. In America, medical bills can be very costly even with an insurance. Being aware of your biggest unexpected expense can help you decide how much to set aside to get through that unexpected event with least amount of financial stress to you and your family.
- What is my monthly recurring expenses such as mortgage, food, utilities, car payments, health insurance? Why do you need to know this? In today's economy there is no such thing as job security, and getting laid-off can happen unexpectedly. Knowing how much you need a month to survive can help you plan save for unexpected job loss.
- How long would it take me to find a new job if I were to get laid-off tomorrow? Consider your field of work, your age/experience, and local job market.
- Would I need to relocate to find an equivalent paying job? What if you have to sell your house to relocate? How much would it cost you to relocate? Think about other people in the same situation trying to sell their house at the same time. This can happen after a mass layoff or a down-turn or worst a recession. There are still several empty houses in my neighborhood looking for renters after a big Intel layoff few months ago. It's hard to sell a house in a depressed local economy, so you may have to keep paying mortgage on your old house for many months while relocating to a new city.
What is Not an Emergency Fund.
Severance Package - My former employer gave out generous severance packages to employees who got laid off this last summer. The company had to take several billion dollars in charge to pay these severance packages. I am glad they did that; however, giving out generous severance packages is not a norm for most companies and would likely not continue in subsequent layoffs. The company has already hinted this to the remaining employees who were given the chance to take the voluntary separation but were contemplating whether to stay or leave.
Therefore, a separation package is not guaranteed unless it is part of your written job contract, a luxury reserved for CEOs and company executives.
Retirement Accounts - Using retirement accounts as an emergency fund is probably one of the biggest personal finance sins. You are taking money from your future to pay for a present need at a very high cost. Not only you are paying higher taxes and 10% penalty, you are also losing on the compounded growth of that money over many years which can amount to 8-10% per year in opportunity loss. Do yourself a favor, don't risk your long-term retirement savings for a short-term current issue.
Investments in Stocks - Investments are not considered liquid assets mainly because their value fluctuates with market conditions. Nobody knows what the market would do in short-term. You should never put yourself in a situation where you are forced to sell your stocks/investments at a loss.
Home Equity Loan/Line-of-Credit - I see so many financial websites portraying HELOC as a good source for emergency fund. HELOC is a loan that you can take against the equity in your house. Equity in your house is a variable asset that can change as the value of your house goes up or down. It's like taking a loan on top of your mortgage, so if you default on your HELOC no matter how small the amount may be, the bank can take your house. Also, if the house value decreases to the point where you have negative equity, the bank can ask you to pay back the HELOC amount you have already spent. I think it's a bad idea to take HELOC as a substitute for an emergency fund, mainly because you are adding more debt on top of an existing mortgage and diluting equity you may have in the house. Why risk your primary house to pay for a short-term emergency when you could have saved some money overtime to pay for such emergencies?
Instant Cash or Payday Loans - These are mostly short-term lending shops that will give you instant cash advance/loan. They normally use liens (such as lien on your car's title) or use your future paychecks/earnings as a guarantee for their return. The problem with such places is that they are designed to trap borrowers in debt as the loans are short-term and at extremely high interest rates (typically around 400% or higher) which makes it very difficult for the already cash trapped borrower to payback the loan plus interest in short period of time.
Saving money in an emergency fund isn't easy for most people; however, it's an insurance to get you out of trouble and lessen your stress when something bad happens. Nothing beats cash when you have a real emergency or need. You will sleep like a baby knowing that you have it covered with an emergency fund and your family will thank you for that.
Disclaimer: Author of this article is not a licensed/registered financial or investment adviser and does not provide financial or investment advice. This article is for informational purpose only. Please use your own judgment or seek a licensed financial adviser before investing. You, the reader, bear responsibility for your own investment and financial decisions.