Having an emergency fund, money set in an easily accessible location like a savings account earmarked for certain situations, is one of the first steps to being financially secure. This is common advice, particularly among financial advisers. Ideally, one wouldn’t tap the emergency fund at all. That sacrifices some earning power because even high-yield savings accounts lose ground to inflation. In return for that sacrifice comes some stability. With an emergency fund in savings rather than the stock market, you don’t have to worry about a potential loss if you need the money in a down market.
If you can plan in advance and protect yourself, you can help reduce the sting of an emergency.
There is, however, a difference in opinion about which circumstances qualify as emergencies. The biggest emergencies would arise with any event that eliminates an income source for an extended period of time.
Sudden job loss. For many people, the primary source of income, and thus the ability to pay for expenses, is a job. Most people in the United States trade their time and effort for a paycheck, relying on a company, small or large, to accept that time and effort and provide remuneration. When job loss is sudden, the primary source of income could disappear just as quickly. Very few of us are “entitled” to a severance bonus, providing a cushion to ease the fall for a period of time, so we must plan accordingly.
It’s dangerous to place your ability to earn income in a sole decision maker focused on a company’s bottom line. As an individual, we each must take our income into our own hands as much as possible, and that includes always being prepared for job loss. Part of that preparation involves having an emergency fund available, keeping a current resume, networking with colleagues, seeking recommendations, and studying the industry.
Even with preparation, the loss of a job can be damaging to your finances, and the effect can last long after you find your next job.
Death or medical emergency of a family member. While life insurance can help deal financially with death, it doesn’t cover everything. There is an entire industry designed around planning for death, but an emergency fund will always be necessary. As relatives age or gradually experience a decline in health, you have time to develop expectations and prepare financially, but unfortunately, death is not always this graceful. Emergency funds can be used to help pay for these hopefully infrequent events, from flights to visit distant family members to final arrangements.
Acts of nature. In New Orleans prior to Hurricane Katrina, residents wary about hurricane damage to their homes were encouraged to buy insurance policies covering wind and rain damage. Many insurance policies provided no relief following Katrina because the damage done to homes was determined to be due to flooding. According to USA Today, only one-third of homes carried federal insurance which included protection from flood damage. Many residence thought they were covered in the event of a hurricane, but the insurance companies disagreed.
A typical emergency fund with three to six months’ worth of expenses may not have solved all problems in this situation, but it could have helped. Natural disasters are not always as damaging as Hurricane Katrina, and planning for total destruction will in most cases be excessive, but when designing an emergency fund, it’s helpful to factor in what is likely for your location.
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 may need to at least cover your deductibles, but also fill in any gaps left after payments arrive. The fund can help pay for a new car if needed.
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 will be able to re-establish the emergency fund.
If delays in income extend longer than six months — personally, I would only accept this from an employer for a month at most, if at all — it is time to find a new job, if possible.
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 better to be prepared to face the consequences.
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.
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.
What do you think?
I’m sure there are many emergencies and an infinite number of non-emergencies I’ve neglected to mention. I will also bet the total of my emergency fund that some readers will disagree with some of my classifications. (Gambling: not an emergency; Paying your bookie: possibly an emergency.) Please share your thoughts.
Updated September 17, 2011 and originally published August 18, 2008. If you enjoyed this article, subscribe to the RSS feed or receive daily emails. Follow @flexo on Twitter and visit our Facebook page for more updates.