An emergency fund is not a true savings or investment. It is money that is set aside for the unexpected. It is there just in case something goes wrong. If you lose your job, unemployment pay only covers a portion of your paycheck and does not cover other benefits like health insurance. If you need your car to drive to work, what would happen if the engine blew up? Would you have enough to cover the cost?
These are some common scenarios where an emergency fund can be a lifesaver. It will only work if it is easy to access and there is enough money there. The question I often hear is… how much is enough and where should I put the money?
For the question of where to put your money – definitely not under the mattress. While some people believe that is the best place to have easy access in an emergency… your emergency is more likely to be house fire than a bank failure. In the case of the cash hidden in your house, it could literally go up in flames.
The best place for an emergency fund should be safe and easy to access. No money market accounts or investments. Emergency funds should go into a straight, no fee, savings account in a reputable bank protected by the FDIC. Yes, I know these accounts pay very little interest – but remember… your emergency fund it not a true investment.
How much to put away is the other common question. This one does not have a simple answer. Many money professionals will recommend at least three months salary, with six months preferred. While this is a good guideline to start – also keep in mind the following:
1. Always have at least enough to cover all your insurance deductibles. If you house caught on fire you could potentially need to have the deductible on your home owners insurance, your cars if they happened to be in the garage and even your health insurance if someone was injured.
2. If you lost your source of income, how long would it take you to recover? If you have a job in hot demand and got laid off, you might be able to find a new job in a couple weeks. In turn, if you own your business and it goes bankrupt… it can take you months to find a new source of income.
3. Do you have dependents? Then you need to consider their needs and costs.
4. Look at your bare budget… how much do you need to live on if it was short term?