The Emergency Fund

by Roy Wiersma

Setting up an emergency fund is one of the key steps or principles that will provide you with peace of mind regarding your life, especially when it comes to finances.  By setting aside some money for the eventual mishap you create a barrier between you and financial damage or ruin.  There are other tools that do this, but the emergency fund is easy to create and has few barriers to being used in times of distress.

The emergency fund is an evolving mechanism.  As your financial situation changes so does your emergency fund.  The key principle however remains the same.  You want to set aside enough money to weather a storm that life throws at you.  As you become more stable and more successful you have the privilege of being able to weather larger storms.

Where to start

Go for an emergency fund of $1000.  This number is somewhat arbitrary, but here is the basic set of reasoning.  $1000 is enough for a surprise car repair, one of the most common surprise expenses.  It is enough to pay a portion of rent or buy gas to get to work.  It is enough money to keep the essentials taken care of to keep the finances from collapsing.

After you create a $1000 emergency fund then you have a choice to make.  

Option 1 is to start paying off non-essential debt(usually credit cards).  In the long term this will save you money.  Once the debt is paid off, proceed to option 2.

Option 2 is to build the emergency fund up to enough cash to cover 3 months of essential expenses.  Depending on your income this can be challenging.  3 months is a good number for a few reasons.  Firstly 3 months is usually enough time to adjust if something unexpected happens, like the loss of a job.

For example:

1. Monthly income $3240

2. Car $240

Housing $1530

Phone $47

Insurance $54

Debt $200

1. Groceries $397

Fuel $124

Utilities $230

Subtotal of the essentials $2622

Given these numbers, the emergency fund should be $2622 x 3 = $7866.

What’s next?

At this point paying down debt needs to happen if it hasn’t already happened.  The reason debt needs to be targeted is simple.  It costs more security to keep the debt than building the emergency fund provides.  The psychological and financial benefits of larger emergency funds are reduced as the fund grows.  This is called a Pareto distribution.  The first 20% of the money in the emergency fund creates 80% of the security.  Paying the interest on the debt is not worth the 20% extra security beyond 3 months of emergency fund.

The only debt you can consider not paying off are student loans and your mortgage.  You should absolutely stay current on those, but the decision to pay those off is more complicated because of the relatively low interest rates and numerous programs surrounding those types of loans.  Since making this determination is complicated, it is covered in a different article.   

The Last Step

After your debts are paid down according to your personal plan, then you want to aim for an emergency fund of 1 year.  Anything over a year is overplanning with very rare exceptions (extreme medical situations or major financial overreach).  Any money beyond that you can now start looking into savings and investment.