An emergency fund is the cornerstone of good financial management, regardless of which personal finance guru you listen to. A small emergency fund of a few hundred to a few thousand dollars can make all the difference when you’re trying to make steps to become financially independent.
Saving your emergency fund in a high-yield savings account. Ideally you won’t have to tap into your emergency fund at all, but there’s a reason you’ve got that money saved. Planning ahead can keep you from going into more debt if you’re trying to become debt free. Or it can help you make better financial choices out of a place of security rather than scarcity.
But here’s the thing: an emergency fund doesn’t do you a whole lot of good unless you can adequately define what is and is not an emergency. So before you save your first dollar in that emergency fund, think through what constitutes an emergency for which you’ll tap into your fund. (If you’re married, be sure you have this conversation with your spouse, too!)
Defining an emergency ahead of time will help you keep your paws out of that money in occasions that feel like emergencies but really aren’t.
Sudden job loss. For most people, the primary source of income, and thus the ability to pay for expenses, is a job. Most people aren’t entitled to a severance bonus in the event of sudden job loss, which means that paying bills could quickly become impossible after sudden job loss.
One part of preparing for such a situation is to take diversify your income and to always being prepared for job loss. Having an emergency fund is a big part of this preparation. An emergency fund that covers a few months’ worth of expenses can help you weather the storm while you find another job.
Ideally, your emergency fund would cover six months’ worth of expenses or more, giving you plenty of padding in the event of job loss. But you may not need quite this month, especially if you’re living in a two-income household where one spouse’s income can cover most or all of the essential expenses.
Regardless of the size of your emergency fund, sudden job loss is an acceptable time to tap into that fund to pay expenses that are essential while you work on getting another form of income.
Death or medical emergency of a family member. Life insurance can certainly help deal with the death of a family member, especially when it comes to funeral and end-of-life expenses. But these policies can take time to pay out, and they may not cover your family’s additional expenses in the event of an extended family member’s death, including travel expenses.
If your parents or other close family members are aging, it may be a good idea to set aside money specifically for such expenses. But if one of these events occurs before you’re prepared, you can tap your emergency fund to meet necessary expenses.
Acts of nature. When it comes to protecting your home, car, and other personal possessions from natural disasters, having the right insurance coverage is essential. For instance, if you live in a hurricane-prone area, you may need flood insurance, even if you’re not technically in a high-risk flood zone.
The fallout of Hurricane Katrina was a prime example of the importance of the right kinds of insurance, as many New Orleans residents thought their insurance would cover their homes when it really didn’t.
In cases like this, an emergency fund probably won’t cover rebuilding your whole life. But it could prevent you from going into debt when you have to flee your home for a time and stay in a hotel, pay for flights, or incur other emergency expenses.
Car accidents. Auto insurance is generally helpful when it comes to covering for damage due to car accidents, whether caused by you or another party. Often, insurance won’t cover everything you need. Your emergency fund needs to at least cover your deductibles, but should also fill in any gaps left after payments arrive.
If you don’t absolutely have to have a car–like if you can use public transportation to get to work and the grocery store–you may not want to tap your emergency fund to help pay for a new vehicle. But if you must have a vehicle, a new-to-you car could be a legitimate use of your emergency fund.
Essential work expenses. Some expenses that may not seem like an emergency to others could be if you require certain things to get your work done. For instance, if you work from home and your internet goes out, you might have to dip into your emergency fund to pay for a new modem so that you can keep working to bring in an income.
Surprise tax bills. While review and planning should prevent this occurring, occasionally the IRS finds something overlooked. It happens to even the most diligent. The IRS will usually allow a payment plan to extend repayments over time for an additional fee, but an emergency fund can help cover the liability.
Delay in income. I used to work for a non-profit which, before I had started working there, had a nasty reputation of not keeping enough funds in their payroll account to cover the paychecks for the ten or so on staff. I’ve had friends working for start-up internet-based companies who were asked to forgo paychecks for a time period for the good of the company in its initial building stages.
With an emergency fund with three to six months’ expenses, you won’t be in danger of failing to cover your bills. Once the paychecks catch up, you can re-establish the emergency fund. An emergency fund in these situations can help you pursue dreams with new or non-profit companies, though you shouldn’t accept employment at a place that regularly delays its employees’ paychecks.
Sudden relocation. Usually, if your employer determines that your job should move from New York City to Ogden, Utah, they will compensate you for your relocation. That isn’t always the case, and your option may be to forgo opportunities within your company and business by quitting your job or accepting the relocation and the accompanying expenses.
The decision is personal, but it’s nice to have an emergency fund that can at least give you the option to pick up and move should an unexpected offer arise.
Unexpected home repairs. Regular repairs on your home should be a part of your overall budget. But sometimes the unexpected happens. A washer or dryer goes kaput. Your fairly-new roof starts leaking. Or your heat goes out in the middle of winter.
It’s important to look at these situations individually so that you can determine if they truly are emergencies. If you have a large family and live in an area without laundromats, a washer going out may truly qualify as an emergency. But if your air conditioner goes out in the summer, you could most likely live without it until you save enough money to fix the problem.
What does not qualify as an emergency?
I’ve heard of people using emergency funds for expenses that are clearly not emergencies. While everyone’s definition of an emergency is different, if you want to make the best use of your money, I would suggest not tapping money earmarked for emergencies for these expenses. That said, you can save separately for these expenses.
Certain medical emergencies. Sometimes medical emergencies justify tapping the emergency fund. Even after insurance is applied, a minor surgery can cost thousands. But before you pay it off with emergency funds, talk to the medical provider or hospital. Often, you can put your balance on a payment plan and pay it off interest-free. If this is the case, choosing interest-free payments may be better than draining your emergency fund.
Vacation. It’s great to get away from your daily responsibilities for a time, but even if your therapist recommends an immediate vacation, you shouldn’t dip into the money set aside to cover emergencies.
A buying “opportunity” in the stock market or real estate. If you’re interested in timing the market or want to buy a house for the fun of it, save separately for the occasion. Most people overestimate their ability to time the market and could find themselves on the losing end of an investment at the moment they need the cash for a true emergency.
Out-of-town visitors. You just heard your friend from college would be in town for a weekend, and she’s suggested getting together for an evening out. If you don’t have extra cash flow at the moment, you might want to suggest a frugal option. Don’t feel you have to impress her by going to the fanciest restaurants and clubs, particularly if you have only your emergency fund available.
Mid-life crises. Recently divorced and quickly aging? It’s time to buy a convertible sports car. That seems to be the accepted path, but it can be a dangerous road to travel, particularly if your ex-wife has half or more of your money. Don’t dip into your emergency fund to buy a new sports car just because you want to feel young again. It may, however, be time to get together with an old college friend for an evening out.
Keeping up with the Joneses. The Joneses buy what they buy because they have no problem with debt. If you’re conscious about spending, you’ll never keep up with the Joneses in the accumulation marathon, nor should you feel the need. They’ve added a sun room and an in-ground swimming pool, but for all you know, they could be paying for it for years. Resist the temptation to match or exceed appearances, whether with debt or by tapping the emergency fund.
Ultimately, It’s Personal
Some people are likely to disagree with me on this list, and that’s okay. Ultimately, deciding how to spend your emergency fund is personal. And it also depends on how much emergency fund you’re dealing with.
If you have a six months’ worth of expenses in the bank, you might pull $1,000 out to buy a new washing machine when yours breaks down. After all, you need to get laundry done, and that is a drop in the bucket compared to the account’s total balance.
But if you only have $1,000 in the account and your washing machine conks out? Consider schlepping your laundry to your mom’s for a couple of months while you save up for a used washing machine from Craigslist to replace it!
Updated May 20, 2017 and originally published August 18, 2008.