I have decided it’s time to get control of my money. Your plan sounds workable, but I talked to some friends about it, and they think I would be better off using a credit card for emergencies. Can you explain why you advise saving a separate emergency fund?
When bad, unexpected things happen, like a job layoff or a blown car engine, you shouldn’t depend on credit cards. If you use debt to cover emergencies, you’re digging a financial hole for yourself. My plan will walk you out of debt forever, and a strong foundation of any financial house includes an emergency fund.
Putting together a fully funded emergency fund is Baby Step 3 of my plan for getting out of debt and gaining control of your money. Before you reach this point, however, steps one and two should be completed first. Baby Step 1 is saving $1,000 for a starter emergency fund. Baby Step 2 is where you pay off all debt, except for your home, using the debt snowball method.
A fully-funded emergency fund should cover three to six months of expenses. You start the emergency fund with $1,000, but a full emergency fund can range from $5,000 to $25,000 or more. A family that can make it on $3,000 per month might have a $10,000 emergency fund as a minimum.
What is an emergency? An emergency is something you had no way of knowing was coming—an event that has a major, negative financial impact if you can’t cover it. Emergencies include things like paying the deductible on medical, homeowners or car insurance after an accident, a job loss, a blown automobile transmission or your home’s heating and air unit suddenly biting the dust.
Something on sale you “need” is not an emergency. Fixing the boat, unless you live on it, is not an emergency. Want to buy a car, a leather couch or go to Cancun? Not emergencies. Prom dresses and college tuition are not emergencies, either.
Never rationalize the use of your emergency fund for something you should save for. On the other hand, don’t make payments on medical bills after an accident while your emergency fund sits there fully loaded. If you’ve gone to the trouble of creating an emergency fund, make sure you are crystal clear on what is and isn’t an emergency.
Also, keep your emergency fund in something that is liquid. Liquid is a money term that basically means easy to access with no penalties. I use growth-stock mutual funds for long-term investing, but I would never put my emergency fund there. I suggest a money market account with no penalties and full check writing privileges for your emergency fund.
Your emergency fund account is not for building wealth. It’s an insurance policy against rainy days!