We never know where the next crisis will come from. We face personal financial crises from layoffs and other financial hardships that wreak havoc on our lives. We also face crises from external sources, albeit a pandemic, severe weather, or major economic disruption, such as with the 2008 financial crisis.
Facing life's crises is never easy – otherwise they wouldn't be crises! Financial problems associated with many of life's crises exacerbate the problems of already difficult situations.
But the core financial preparation recommended by experts — an adequate emergency fund — has helped many millions weather pandemics, severe storms, and other crises with fewer consequences.
One area where experts disagree is timing. Some experts recommend eliminating all debt before beginning to save for an emergency fund. Other experts recommend saving for an emergency fund as soon as possible, building your emergency fund at the same time you are working on paying down debt. The second method wins.
Emergencies happen to people who aren’t yet debt-free.
In the absence of an emergency fund, people do what they always do – add more debt.
This often becomes a cycle, pay down debt, add to debt, repeat — debt meets Groundhog Day. Building an emergency fund while you are still working on paying down debt gives you a small fund – the one you’re building – to use for emergencies. You are less likely to use debt for an emergency; less likely to enter into the debt-repeat cycle.
The logic of paying down debt first is to minimize the high interest costs of revolving debt. But if you continue to incur debt because you have no savings that doesn’t happen.
Most people will be better off by beginning to build an emergency fund as soon as possible, working on paying down debt as you go.
Emergency Fund 101: How Much to Save for a Crisis
There are two parts to the question of how much to save. There needs to be a goal, a target for the size of your emergency fund. There also needs to be a rate, an amount you allocate to the fund to get to the goal. Both are forms of “how much?”
The expert advice of three to six months is great but leaves many people uncertain of what they should do. That’s one problem.
The other problem is scope; many people don’t see that as realistic. When it seems impossible to save a couple hundred bucks, a few months expenses seems like a deal-breaker.
In order to build an emergency fund, you have to save. If you can only start out small, then start out small. Perhaps you can save only $20 a week. That’s fine, do that. Start with a goal of $1,000.
Don’t worry about whether you should technically have three months or six months until after you get to $1,000. That doesn’t have to be today’s problem, and we really don’t want it to be today’s obstacle. The first thing to do is to begin saving.
Ultimately the question of where to land in the recommended three- to six-month spectrum is a question of risk.
One aspect is the stability of your personal financial situation. If you have job insecurity, health issues, or other concerns where you could end up with large unexpected bills or periods of unemployment, it might be wise to work toward a larger emergency fund.
If everything in your world is very stable and secure, you might be comfortable getting to the three-month level and then allocating more toward your long-term goals. It’s simply a matter of the potential volatility of your financial situation and your comfort level with risk.
Managing Your Fund
Your emergency fund should be stable and accessible in case of a crisis. Those are its primary requirements. They trump return or other factors. In an emergency, the funds need to be there and you need to be able to get them.
The accounts that meet these criteria are savings accounts, money market accounts, and certificates of deposit (CDs). Savings accounts and money market accounts should give you ready access to your emergency funds at any time without penalty. CDs often have a penalty for premature withdrawal.
The trade-off is that you will most likely earn higher interest with the CD. The solution is to build a base in a savings or money market.
This would be your whole fund if you’re working toward the $1,000 starter-fund; otherwise, it might be one month of expenses. Then any balance of your emergency fund could be in a CD or other higher-interest account that has no volatility.
Overfunding Your Fund
Once you’ve built your emergency fund to your desired level, you should consider continuing to add additional funds.
Your emergency fund is there to help you with the periodic unexpected financial needs that occur on both routine and non-routine bases.
If you are a homeowner, you’ll periodically have emergency home repairs; if you’re an automobile owner, you’ll periodically have emergency car repairs. Continuing to add into your fund will make it far easier to maintain it at your desired level.
If you don’t add to the fund on an ongoing basis, you will probably need to address replenishment periodically as you use it for your emergencies. It’s a lot easier to keep some funding going in and moving any excess out than it is to keep finding ways to replenish it.
The Bottom Line on Emergency Funds
Very often an emergency fund isn't the most important thing we have to face when we’re in a crisis. Our health and the health of our loved ones or others we are concerned about take precedence over money.
But often financial decisions during a crisis are unavoidable. We have to eat, have shelter, and pay some or all of our bills.
Our ability to do so during a major crisis is very dependent on our having done the legwork in advance and having built a suitable emergency fund.
It does make the routine little emergencies like a broken water heater easier to deal with. But major crises like a pandemic or a hurricane show us how truly invaluable it is to have an emergency fund in place.
Everyone suffers to a degree in a crisis. Some have lesser financial consequences as a result of their preparation. That’s the big reason for building an emergency fund.