Building an Emergency Fund

As financial goals go, building an emergency fund is an honorable one, features high on many people’s list of priorities. While it might seem self-explanatory, it’s worth thinking about what it is, what it isn’t, and the purpose it really serves.

What is an emergency fund?

An emergency fund is an asset which you can readily access (i.e. a current / “liquid” asset) in the event of an unplanned emergency, such as losing your job, having a medical crisis, or having to to travel urgently to visit a sick relative overseas. Something which you can’t predict, but when it happens, you can’t avoid.

What it isn’t…

An emergency fund isn’t a rainy-day fund, a vacation fund, or a “I’ve really gotta buy that Les Paul on eBay” fund. If you build an emergency fund, deplete it for a non-emergency reason, and then have a real emergency the next day? Well… you might as well have not bothered.

Why do I need an emergency fund?

Simple: peace-of-mind. People respond to emergencies in different ways:

  • Disbelief
  • Emotional numbing
  • Nightmares and other sleep disturbances
  • Anger, moodiness, and irritability
  • Forgetfulness
  • Flashbacks
  • Survivor guilt
  • Hypervigilance
  • Loss of hope
  • Social withdrawal
  • Increased use of alcohol and drugs
  • Isolation from others

Crisis intervention and trauma response: theory and practice
— Barbara Rubin Wainrib, Ellin L. Bloch (1998)

These aren’t states of mind in which you should be making important, time-sensitive decisions about your finances. Your emergency fund give you the peace-of-mind of knowing that whatever happens to you, money needn’t be one of your worries — at least in the short term.

You won’t have to take a loan from your 401k. You won’t have to redeem your CDs early. The only impact of using your emergency fund? You need to top it up again when the emergency is over.

How large does my emergency fund need to be?

The size of your emergency fund depends entirely on your personal circumstances. I’ve seen varying recommendations that your fund should cover between 3 – 8 months of your non-discretionary expenses (e..g mortgage / rent, food, bills), but with the purpose of the emergency fund being to provide you with peace of mind, the size of the fund you should aim for is determined by whatever you’re personally comfortable with. If you have a mortgage and kids, you’ll probably want more of the comfort-buffer provided by an emergency fund than if you’re single and renting.

If you’re heading for a three month emergency fund, let’s look at how much that might be:

Per month Three months
Rent $1,500 $4,500
Groceries $500 $1,500
Bills $400 $1,200
$2,200 $7,200

Even a three month emergency fund is still a sizable chunk of cash to save, and may seem daunting. Make your goals incremental. In the case above, perhaps your first emergency fund goal is $1000. Having any emergency fund is better than none — anything you have saved will make your life easier in a crisis. Then, aim for one month’s expenses ($2,200). It might take a year. It might take three years to hit your three-month emergency fund goal ($7,200).

    Time to save*
    Saving per month $1000 $2,200 $7,200
    $50 20 months 44 months 144 months
    $100 10 months 22 months 72 months
    $200 5 months 11 months 36 months

    * Not accounting for interest, which will likely be minimal during the period of saving in an instant-access savings account, and probably slightly higher but still small if you opt to keep your emergency fund in a CD or ladder of CDs.

    In summary: how much you should save to feel comfortable is dependent on what your likely needs are in an emergency.

    Saving for an emergency fund should be a high priority for all individuals who don’t currently have one. We’ll discuss how to decide where this ranks among your other potential high priority goals (e.g. paying off high-interest credit cards) in a later article.

    Other considerations

    Another thing to consider in setting your emergency fund targets: health insurance deductibles. This isn’t an article on health insurance, and you should consult with your employer and insurance provider to find the best option for you. However, if you are young and healthy, you may have opted for a health insurance plan with a high deductible, which could be several thousand dollars. You chose to spend a little less on a plan with smaller premiums each month, with the assumption that you will not need medical treatment. If you do get sick or have an accident, you could be stuck with a very significant hospital bill.

    If this situation applies to you, consider this:

    Find the difference between the lower-premium plan you chose, and the more expensive one with a lower, or zero, deductible, and consider putting this amount from each paycheck into your emergency fund. If these savings, over a year, would add up to more than the high deductible of your plan, you may have found a viable way to partially self-insure yourself:

    • If you don’t get sick or injured during the year, and have no medical bills? You’ve accumulated a substantial amount towards a general emergency fund, and can continue the savings next year.
    • If you do get sick or injured, and require treatment? You have an account with sufficient savings to cover your deductible, and you are not penalized for your choice of the ‘cheap’ plan. You either re-start saving for your new deductible and repeat the process next year, or re-evaluate your health risks and consider switching plans.
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