Emergency Funds have a unique place in the family tree of personal finance. Most of us know the Golden Rule of having ‘”3 to 6 months of living expenses” held in a separate account in the case of a financial emergency. Simple, right? Not exactly. In my experience, when I talk to ten different people, I will hear ten different variations on the concept of the emergency fund (EF). One person may keep their EF as cash in an envelope hidden in the sock drawer. The next person has their EF invested in stocks via an app on their phone. The third person says it is three months of “bills” which is just housing, car payment and utilities. The next person says it is six months of income which may or may not be covering all the monthly expenses. The last person says it’s mixed in with their everyday checking and just a “buffer” for large expenses. You may even be thinking to yourself that your idea of an EF is completely different than any of these mentioned…and may even be different than your spouse / parent / best friend’s definition of one. So, with all these variations of an EF which one is right? More importantly, which one is right for you?
According to some, you should be covering your critical living expenses in case of a job loss. According to others, you should be covering unexpected expenses such as car or home repairs. Which one is right? Actually….both! According to the Consumer Financial Protection Bureau, an emergency fund is for all financial emergencies which includes both unexpected large expenses and unplanned loss of income. Which definition is right for you really depends on your personal values and what is most important to your financial well-being. If your income is higher than your monthly bills, a replacement of lost income is probably most important. If your income is the same as your monthly bills, a small nest egg for unexpected expenses may feel right. As long as you have a clear definition that these funds are earmarked for emergencies, and not for Christmas gifts or family vacations, whatever you decide will be right for you.
Here is another misunderstood part of an Emergency Fund: 3 to 6 months of what exactly? Income? Expenses? That seems to be the great divide. While those two terms are often used interchangeably in this context, I’d like to settle the score once and for all. For a lot of Americans, their income and their expenses are the same number so I can understand why it’s an overlooked detail. But for some Americans, their income can be much larger than their expenses, so this point deserves clarification. On the record: I am Team Expenses. When you are using your EF as a bridge between jobs, the funds are there to pay your bills….and not just the “essential” ones. I have known many people who are between jobs, and in reality, they are still going out with friends to dinner, paying for their kids’ soccer jerseys and attending the concert they bought tickets for months ago. I suggest looking at your budget (yes, I said budget) and getting a realistic handle on the total outflow of cash used to pay for the “day to day” of living your life. Don’t forget that while you may no longer have the expense of a payroll deduction to your retirement account, you may have to increase what you are paying out of pocket for medical insurance…so know have eyes wide open on that one.
And last, when is it okay to dip into your emergency fund? I’ve known families to use it for just about every expense that’s outside of their monthly budget and I’ve known families that refuse to use it at all…even when there is a bona fide financial emergency. Neither extreme lead to great financial mental health. I firmly believe the funds are there for a reason, and when that reason comes you must have the mental strength to use the funds for their intended purpose. For those people who are afraid to dip into the EF (because then they won’t have any money left in the EF), my recommendation is to have a plan on how to start to build it back up. Maybe it’s a dedicated monthly deposit, canceling an upcoming “want” purchase, getting a side hustle or earmarking that beloved tax refund. Having a gameplan not just for the unforeseen financial emergency, but for how to refill the coffers after the emergency is done and paid for, is one of the least talked about aspects of an emergency fund yet is just as important in case of the dreaded “double whammy” of back-to-back financial emergencies. That is when the rubber really meets the road, and the mental health aspect of financial planning becomes a critical piece of the puzzle.
Kimberly Enders CFP® CWS® CERTIFIED FINANCIAL PLANNER™
Enders Wealth Management
37800 Van Dyke Ave, Suite 125
Sterling Heights MI 48312
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