The Emergency Fund: What It Is and Why You Need One

What is an emergency fund?

The standard response to that question is: “a cash reserve of three to six months of living expenses”. Note that I said living expenses and not salary. If you’re single without children, you’d probably be safe by stashing away only three months of expenses, however, if you’re married with children, I’d recommend the larger, six month cushion. The more dependents you support, the more cash you’ll want to have on hand for unexpected expenses and emergencies.

Why do I need an emergency fund?

Loyal Dave Ramsey fans will vehemently disagree with me, but in my opinion, establishing an adequate emergency fund is the very first step toward becoming financially independent. By having a completely liquid cash cushion to fall back on during tough times, you’ll rest at ease, knowing that you’re fully prepared when disaster strikes.

To illustrate the difference between my and Dave Ramsey’s philosophy on emergency funds, let’s make up a scenario. Let’s say Veronica is mother of two young children and is barely getting by on her teacher’s salary of $30,000/year. She has two, high interest rate credit cards with a total balance of $9,000 and is making slow but significant progress in paying them off.

One day, one of Veronica’s children gets into an accident at school which sends her to the hospital and requires an expensive surgery. Veronica is now forced to pay the $500 deductible plus 20% of the $15,000 surgery for a grand total of $3,400.

With an adequately funded emergency fund, she could simply write the check, but without one, she’d be forced to put the expense on a credit card, sending her even further into debt. Once you factor in the interest she pays on the balance and any fees, her debt can quickly spiral out of control.

Where should I keep my emergency fund?

First of all, it’s important to understand that your emergency fund needs to be completely liquid. You’ll need to have near-immediate access to the cash in the event of an emergency, so stocks, mutual funds, and other similar investments are obviously ruled out.

The best vehicle to park the cash in your emergency fund is in a high-yield savings account that is linked to your primary checking account – online savings accounts from ING and HSBC are terrific choices and are currently offering a rate of 3% or better. A money market account is another option, but typically offers a lower interest rate.

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