With the devastation from Hurricane Sandy still affecting millions in the northeast, I figured I would talk about the true importance of an emergency savings fund. There is always the general consensus that you should have about 6 months worth of living expenses saved up in your emergency fund. There are other thoughts about only having about $1,000 in your fund. If you are working on reducing your debt, then the $1,000 can be a good number, but if you have no debt, then you should really focus on the 6 months worth of expenses. While these numbers can fluctuate, the true importance of an emergency fund is that is saves you in the event of an emergency.
What is an emergency?
The dictionary definition states an emergency as “a sudden, urgent, usually unexpected occurrence or occasion requiring immediate action.” This is exactly what an emergency is, something that is unexpected, but requires immediate action to rectify. This could be a weather related emergency or even a financial emergency. We never know when an emergency will hit, hence why it is unexpected.
Never use your retirement accounts as emergency funds.
I have heard from “financial experts” that putting a lot of money into savings it not the right way to deal with emergencies. Some indicate that you should put your money into an investment account, such as a 401k or IRA, so your money will grow at a higher rate than in a standard savings account. This method of protection is ridiculous.
The reason why we have a 401k and IRA is to make sure we have enough for retirement. We should never use them as our emergency funds. The main reason is, is most cases, you will charged a fee for pulling out the money. On top of being in an emergency, now you have to worry about getting charged a fee for using your own money.
The biggest issue with using your investment accounts is that most people to do refund them back to their original balance. When unexpected expenses come around, you need the flexibility of a simple savings account to handle dealing with the issue. There is no simple way to pull money out of your investment accounts to deal with problems quickly.
If anyone recommends only using your retirement account as an emergency fund, then I wouldn’t listen to them any further for financial advice.
So, do you fund your retirement account, or save for an emergency?
One method that I have adopted when dealing with my savings is a dual prong approach. I fund both accounts. After paying off my credit cards, I worked on saving the $1000 in my account. This was the bare minimum that I wanted in there. Some simple unexpected car repairs can cost you well over $500, which is half of your emergency fund. I knew that $1,000 is not enough to deal with most financial disasters, so I wanted to continue to grow my fund. I also wanted to get a handle on my retirement accounts.
I decided to not only fund my savings account, but also fund my Roth IRA. This way I would be building my savings account up to a level that I could be happy with (only 25% there as of now), and I would also build on my wealth for retirement. This dual prong method is working well for me and allows me to be financially secure during an emergency. While I would never recommend a specific method for everyone, I believe this approach will help most become financially independent.
The easiest way to fund both accounts is to automate your money. I treat my emergency fund and my IRA just like a monthly bill. I setup automatic transfers from my bank into my emergency fund at my credit union as well as into my IRA account at Betterment. I know exactly how much money is leaving and I work it into my budget. This is the easiest way to continue funding the accounts without forgetting.
Can I use cards or lines of credit to help during an emergency?
The answer to this question is yes. You can use credit cards or lines of credit to help you get our of an emergency, but that should be the very last option. When putting an emergency on plastic, you are essentially knowing that you will be paying much more for your emergency. If you don’t have a 0% APR card, then you will be paying interest. This interest will add up over time and will make it much harder to pay off the debt.
I am aware that many people have credit cards for their time in need, but many lack the discipline required to pay off the card in a reasonable time frame. If you have money sitting in your savings account, then you don’t pay more than you should. That is what the money is there for. It is not for discretionary spending, it is there for only emergencies. If you use credit cards to pay for emergencies, then you will just dig yourself deeper into a hole.
The only time I would recommend using a credit card for an emergency is when you have enough money in your savings account to pay for the emergency situation, but you get cash back or points with your credit card. If you have the discipline to pay off your card every month, then why not reap the benefits of your card? You can use your emergency fund to make the credit card payment and then everyone is happy.
Only 54% of Americans have more in their savings than they have in credit card debt, according to a Bankrate.com poll earlier this year. While this is understandable with the current economy, it just defines the importance of having an emergency savings fund. If you are working hard on paying down your debt, then you should have at least $1,000 in your savings account. This amount is also given by Dave Ramsey when using his debt snowball method.
If you are debt free, besides your mortgage, then your savings account should have enough to cover at least 6 months of living expenses. This number may be high, but it can save you in the event of losing your job or having to deal with a major unexpected expense. I would recommend trying to fund both your savings account along with your retirement accounts. This will provide you with the best bang for your buck and set you up for financial security in the future.
To know how much you need to save, check out our emergency fund calculator.
Do you have an emergency fund? Do you wish you had more in savings? Let me know below.
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