What Is an Emergency Fund?
One of the central tenets to good financial planning is preparing for the future, whatever it may bring. Therefore, an essential component of a solid financial plan is an emergency fund.
An emergency fund is designed to cover a financial shortfall when an unexpected expense crops up. Your emergency fund can serve as a place to get the money you need when you find yourself short. Because it must be reliable, it needs to hold guaranteed investments. In other words, savings accounts are good for emergency funds, while stocks may not work so well.
An emergency fund, by nature, also needs to hold liquid or otherwise short-term, accessible investments. Ideally, you won’t need to use the money in your emergency fund, and you will maintain it for the long-term. However, this creates an interesting conundrum: a long-term account holding short-term, low-interest bearing investments.
To get around this issue and enhance my return on investment, I like to divide emergency funds into two main categories:
Short-term emergency fund
Your short-term emergency fund is your go-to place when you have an immediate emergency. It should be in an accessible account, which will probably bear little interest. The most important consideration is accessibility. You’ll want a debit card attached to this account and check-writing privileges as well. The purpose of your short-term emergency fund is for smaller emergencies, such as car repairs or replacing a major appliance that has broken. It can also be used as a bridge to get you through the few days until you can access your long-term emergency funds in case of a more extreme situation.
Long-term emergency fund
A long-term emergency fund allows you to save for large-scale emergencies, such as job loss or a major natural disaster like an earthquake or fire, and earn a slightly higher level of interest. Accessibility is still important here, but it’s okay to choose investments that take a few days to liquidate – as long as you have a short-term emergency fund to cover you in the interim.
When you have an emergency fund, you have peace of mind. Your money is on guard, so to speak, just waiting to be called into action. You don’t have to scramble to come up with money you need and you don’t have to turn to credit cards. Even if your emergency fund isn’t big enough to handle everything, it can still help reduce the amount of money you must look for from friends and family, or credit cards.
What Makes for an Emergency?
It is important to realize that an emergency fund isn’t a slush fund for large entertainment and leisure purposes. A new big screen TV doesn’t qualify as an emergency, even if your old TV breaks down.
In order to ensure that your emergency fund is there when you need it, you need to be able to identify a true emergency. A true emergency is a situation that requires some sort of immediate action, and that can affect your long-term well-being or impact the viability of an important asset (such as your home).
Some situations that constitute true emergencies might include:
- A health emergency that is not covered in your health insurance plan.
- The need to travel or finance other arrangements as a result of a family emergency, such as a death in the family.
- Major unexpected car repairs. This can include paying your deductible for damages caused by a car accident or paying for a new engine. Routine car maintenance, however, should be scheduled into your monthly budget.
- The failure of a major appliance. If your big freezer breaks, you may need to pay for a replacement quickly. Keep in mind the best times of the year to buy large appliances.
- Large and unexpected home repairs
- Break in case of recession.