Investment Glossary – Emergency Fund
The term “emergency fund” is one that you may have heard or one time or another. The core principle is pretty straightforward. Emergencies happen. The timing of them can be unpredictable. Sometimes, dealing with and resolving emergencies costs money. Thus, you should prepare for emergencies by having funds put aside to deal with them when they happen. Building an appropriately-sized emergency fund is a basic part of the budgeting process, as it helps to give you a cushion in your financial situation to help you avoid using higher-cost options such as payday loans and credit cards to satisfy short-term cash needs.
It’s important to note that when we talk about emergencies occurring, we aren’t simply looking at massive natural disasters or things like that. Yes, if you house is damage by an earthquake, tornado, hurricane, or any other force of nature, you’re going to have massive expenses associated with getting it back into livable conditions. In some cases, homeowners insurance may help to cover some or all of those costs, but you may be on the hook for large expenses because of what your policy does or doesn’t cover. So obviously, these large-scale emergencies are part of what you save for when you build an emergency fund.
But the smaller emergencies are just as important to prepare for as well, as they tend to happen on a more regular basis, and can add up nonetheless. What do I mean by “smaller emergencies”? Maybe your garage door cables snapped and one of the doors was damaged and you need $1,000 to buy a new one. Maybe there’s a leaky pipe upstairs that you need to get a plumber out to fix before your drywall rots. Maybe your son or daughter has a sports injury that your health insurance covered part of, but you still have a $500 deductible to take care of. Those are smaller emergencies. And while they aren’t as shocking as your whole home being destroyed, they are absolutely things that you need to plan for – because while the exact examples I mentioned above might not happen to you, the sheer amount of stuff that people have and things they participate tend to result in something breaking somewhere on a regular basis. And fixing things costs money.
Now, if you have plenty of income and money to spare, maybe you don’t need an emergency fund if you can cover everything out of your cash flow. But there are two problems with that – first, that’s not the situation most families find themselves in, and second, if you had such great cash flow, wouldn’t you have built up some type of savings with all the extra cash you had anyways? So unless you have literally more money than you can count, you need to build some type of emergency fund.
An emergency fund needs to have a few key characteristics:
- Liquidity – You have to be able to get access to it on a moment’s notice. Your home is not an emergency fund, because if you need to sell it, you probably can’t do it and have the money in an hour.
- Stability – Your emergency fund has to be stable in value so you know it is there when you need it. Yes, you might love investing in stocks. But if you happen to need money from your emergency fund when the market is down 20 percent, that situation could present some problems for you.
- Amount – You could have your emergency fund in a safe and liquid bank account, but if it’s only $30, it doesn’t help you with a $500 expense. An emergency fund has to be of the appropriate scale to make a difference when the emergency strikes.
As you may have gathered from the above statements, the best place for an emergency fund is in a highly-accessible bank account. This will provide a very modest return that likely trails many other investments, but when it comes to stability and liquidity, there are still few options that can rival bank accounts for ease of access and low volatility. And this brings us to trying to answer the final piece of the puzzle – how much money should I have in an emergency fund?