While responsible planning can help prevent a number of painful financial mistakes, no one ever plans to lose their job, get in a car accident or require expensive medical care. None of us know what specific challenges life is going to throw our way, but I promise you there will come a day when you get hit with a massive and unplanned expense. How well you prepare for that possibility could have a huge impact on your long term financial well being.
What is an emergency fund?
As the name suggests, an emergency fund is a safety net account that you can dip into as a last resort to pay for large and unplanned expenses. Air conditioner breaks in the middle of July? That’s what your emergency fund is for. Car gets totaled on the way to work? Don’t sweat it. Lost your job unexpectedly? Your emergency fund will help pay the bills while you focus on looking for work.
Most financial planners recommend keeping 3-6 months worth of expenses in an emergency fund. Additionally, conventional wisdom says that you should make sure to fully fund your emergency fund before starting on other financial goals, like saving for retirement, a down payment on a house, or discretionary spending like a new phone or an expensive vacation. The only time I’d suggest ignoring an emergency fund is if you’re actively working on paying off debt, though even still you might want to try and set aside a month or two worth of expenses in case something comes up on your road to financial independence.
Ultimately you’ll have to analyze your own financial situation, including factors like risk tolerance, job security, and what credit lines you have available to decide how much you want to keep in your emergency fund. If an expense comes up that requires you to dip into your emergency fund – like a $300 bill to tow your car after a flat tire – you’ll want to make sure to take some money out of your next paycheck to replenish the emergency fund.
Much like health insurance or car insurance, emergency funds aren’t fun to think about. The money you set aside here isn’t going to help you retire early or lead a more luxurious life. In fact in an ideal world you’d set aside this money and never have to touch it. The problem is, people without an emergency fund are at a much higher risk of making poor financial choices. If you don’t have an emergency fund, you’re living paycheck to paycheck and your car breaks down, what do you do? You might end up putting the repair bill on a credit card with a high interest rate and getting yourself trapped in a debt cycle, or you might need to take out a personal loan which might be tough to repay. The human brain is wired to underestimate the likelihood of bad things happening, but by being honest about the risks that are out there and preparing for them today, you can keep your financial life on track no matter what curveballs life throws your way.