This past Saturday evening I joined radio talk show host Michael Finney of KGO AM 810 San Francisco on his weekly radio show, “Consumer Talk with Michael Finney,” to discuss my recent post about safe places to keep cash at home. During our conversation I shared with him my Tri-level Emergency Fund Plan, and even though I have mentioned all three levels here separately in the past, I thought it might be nice to present in a single, concise article.

What is a Tri-Level Emergency Fund?

A basic definition of a traditional emergency fund is a pile of money saved separately from other savings goals, and outside of a normal spending account. Its main purpose is for covering emergencies, or required expenses that crop out outside of the normal budgeting process that cannot be cashflowed with regular earnings. A sale is not an emergency, and job layoff, broken transmission or serious illness is – you get the idea.

Emergency funds come in many shapes and sizes, and while experts disagree on the amount that should be saved, everyone agrees that we all should have one adequate to cover some months of required expenses. Whether that number represents one month or twelve months, or somewhere in between, is entirely up to you. I say save just enough to sleep comfortably at night and invest the rest.

Level I:  The In-House Emergency Fund

The first $500 of so of your emergency should be something completely liquid (cash) and saved within arm’s length. This amount could be spread out around hiding places in your home, your car, or at your job (or some combination), or could be locked down in a fireproof safe bolted to the concrete slab under your closet. The point is to stash some cash to cover short emergencies that may happen around the home, when using a debit card or visiting the ATM is not possible. Think state-wide power outage, a family member in desperate need of cash, a local natural disaster, etc. Don’t keep your life savings at home, but stashing a few hundred dollars makes sense.

Level II:  The Local Emergency Fund

I recommend keeping the next $1,000 of your emergency fund in a local emergency fund at a bank or credit union checking account. These funds would cover things like car repairs, broker appliance and late-night calls to the local plumber. The beauty of these accounts is they are local and have check-writing privileges from a local bank, so most service providers in your area would not give you a hassle about accepting a check. If they did, a quick trip to the ATM, or a counter check from the local branch, should resolve the problem.

Level III:  The Mega Emergency Fund

What’s a “mega emergency?” Mega emergencies are the types of emergencies that might require you to live off this fund for a short time. Think job layoff, medical disability, a serious accident, etc. My mom suffered an aneurysm and stroke about a year ago and had to wait six months for disability insurance to begin coverage. Are you prepared to live six months without an income? Most of us are not, and unfortunately, neither was she.

The Mega Emergency Fund is the only place I worry about interest rates, and even then security is a more important consideration. Still, you at least want to stash the money where it will earn a little interest, and the higher the rate, the better. Consider an online savings account (read my ING Direct review), or if you have enough saved, a tiered money market account at a credit union may offer higher interest rates than traditional savings accounts.

A tri-level emergency fund is the ultimate way to diversify your cash portfolio dedicated to emergencies, and when fully funded, should help you sleep better at night. It’s been said that there is no softer pillow than money in the bank. After many sleepless nights in the past with an empty bank account, I would have to agree.

One of the key components of my family’s financial turnaround was the addition of an emergency fund.  An emergency fund may be best described as a pot of money used to handle life’s emergencies while helping you avoid reaching for a credit card. In the past it was these small to medium emergencies, and the subsequent credit card charges, that seemed to keep us on the hamster wheel of debt.

Another thing that helped in our recovery was the mental, and even physical, separation of small piles of money. We accomplished this by opening an online savings account at ING Direct that allowed us to open several additional “sub-accounts.”  We identified a number of unique savings goals and created an account for each one – Christmas savings, a vacation fund, orthodontic services for our kids, etc. We also recently divided our emergency fund into logical (to us) separate piles of money.

Specialized Emergency Funds

The inspiration came from a post I read over at Gather Little By Little about creating specialized emergency funds. I liked the idea of dedicating a portion of money to a specific emergency situation, and the idea folded in nicely with an earlier tweak to our financial plan to create a local emergency fund.

In this economy, it also seemed like a good idea to tag some money available to pay for things like the mortgage, COBRA insurance, etc. in the event of a job loss. Sure, the sum of these expenses could be calculated and serve as your goal emergency fund amount, but knowing I have 6 mortgage payments or 6 months of COBRA in an account helps me sleep at night!

Our Specialized Emergency Funds

• Local emergency fund. This fund represents to the first $1,000 of our larger emergency fund.  Instead of keeping it all in online savings accounts, we like the idea of $1,000 or so saved at a local bank.  We can write local checks for repair services, make cash withdraws, or do business inside the bank branch.

• Mortgage fund. My goal is to have exactly six months of mortgage payments saved in a dedicated account. After watching my mom struggle to stay afloat financially after a stroke and six months of unemployment before disability kicked in, it has strengthened my desire to have this fund in place.

• Family health insurance fund. In the event of a job loss it could be difficult getting rehired in this economy. So having 3-6 months of COBRA insurance premiums sitting around would make me much more comfortable. In fact, if I ever venture out on my own, this fund could provide insurance for a few months (COBRA or a family health insurance plan I shopped for somewhere like eHealthInsurance.com).

• Automotive repair/replacement fund. We combined auto repairs and replacement funds (where I will continue sending our car payment after it is paid off this month). When we have enough saved to buy a car for cash, we’ll upgrade my wife’s current car and I’ll drive hers a while longer.  In the mean time, the funds will be used to repair my old van, which has been limping along here lately.

• Household repairs fund. The remainder of our emergency fund is in a generic account we’ve labeled “household repairs.”  This could cover things like a new hot water heater or a refrigerator repair.

I feel compelled to add this small warning – be careful not to add too many specialized emergency funds, and try not to confuse them with other targeted savings goals you may have.  For instance, my car replacement fund really could have stayed separate from my repair fund, much like a “new house down payment” savings fund would likely be separated from household repairs.

Basically, do what works best for you, but don’t too carried away creating dozens of accounts or you will create more headache accounting for the money in the long run.

One of the most frequently asked questions in the personal finance realm is, “How much should my emergency fund be?” The question is usually answered with a canned response such as, “Three to six months of expenses.”  Well, I have my own theory on the size of emergency funds, and it has more to do with me sleeping at night than a finance guru’s personal opinion.

Still, at some point excessive savers run the risk of saving too much for a rainy day.  After all, there are plenty of sunny days to take advantage of, and doing so may require a little cash.  Every situation is unique, but as a rule I would suggest not saving more than one full year of income in a fund designated for “emergencies.”  Most (not all) job layoff situations are resolved within one year, and most large emergencies can be covered by the equivalent of twelve months of income.

You may be like us and have savings goals that reach higher than one year’s worth of income.  That’s okay; just designate separate piles of money for each goal.  For instance, when we become debt free I plan to start saving in a “Financial Independence” fund (it’s purpose is self-explanatory) to hold proceeds from my working capital in other investments.  Ideally, I would like to have at least one year of income in this savings fund, if not more, but it will be kept in a separate fund (ING Direct allows you designate separate, or “sub-accounts”–great for separating savings goals).

Some folks lean towards the Dave Ramsey principles of a very small, beginner emergency fund while you are working to become debt free.  I understand the logic behind this idea, but only having $1,000 to our name feels a little risky to us.  I would rather accumulate a minimum of three months of expenses and then attack the debt.  After all, $1,000 doesn’t go very far these days towards household repairs, replacing dead appliances, or surviving a layoff.

So How Large Should My Emergency Fund Be?

The bottom line is there is really no right or wrong answer to the question.  Stop and think about all of your liquid assets and gauge your immediate reaction.  Are you comforted by this amount?  Are you worried it won’t be enough to cover the next bill from your mechanic?

Let that initial response guide you.  If you are not at peace knowing how much you have in savings, add more.  And because men and women often have a different number that makes them at peace, financially, couples should opt for the larger of the two amounts required to make each spouse feel secure.  Once you reach your target amount dedicated for “emergencies,” attack your debts and then move on with your financial life by funding retirement, college for your children, etc.

How much is in your emergency fund?  If you don’t want to share numbers, just tell us how many months of expenses you have saved up.

A solid emergency fund is the foundation of any solid financial plan.  Having a little tucked away for rainy days puts some distance between you and the ledge of a financial cliff that could give way at any moment–usually from broken appliances, car repairs or major medical issues.  Most financial planners advise people to have about 3-6 months worth of expenses saved in money designated for emergencies only.  However, over the years I’ve found this 3-6 month rule to be too arbitrary, because there are a variety of factors to consider when deciding how large to grow your own emergency fund.

Emergency Savings:  Just Starting Out

Dave Ramsey’s plan calls this first phase of savings the “baby emergency fund.” It is represented by $1,000 in a savings account.  This first $1,000 in savings is the first of seven financial baby steps recommended by Ramsey, but over the years of putting his plan in action we’ve found this amount to be too low.  $3,000 is actually a better amount for our family, and we arrived at this number rather unscientifically by floating an amount that made both me and my wife comfortable.  Not unlike most couples, our emergency savings balance represents a “middle ground” that we both compromised to reach because of our differing degrees of risk we were willing to take on.  We have our emergency fund stashed away in an ING Direct high yield online savings account.

Men Are From Mars

My wife is more conservative than I am when it comes to the amount of risk she is willing to accept.  I am on the opposite end of the scale, opting to take on more risk for the opportunity for a larger reward.  Our differences are not unlike most married couples, where one spouse helps balance out the personality of the other.  I agreed with her that the $1,000 baby emergency fund seemed a little low, and thought we should double it.  She thought $5,000 sounded good to her.  We met in the middle (almost) and settled on $3,000.

How Large Should Your Emergency Fund Be?

I mentioned in the opening that there was no magic formula for calculating how much should be in your initial emergency fund.  But if I were attempting to devise such a formula it would probably look something like this:

• $500 per Spouse
• $500 per Child
• $1,000 Extra for Single-Income Families

Following this formula we arrived at the $3,000 amount for our family.  If my wife worked outside the home, we could probably live with a $2,000 beginner emergency fund, because if I became unemployed we would still have her income to fall back on.

A Fully-Funded Emergency Fund

Once you are completely debt free I recommend saving a fully-funded emergency fund which represents 6-12 months of living expenses.  For most families this would probably look like $10,000-$15,000.  Remember, in a real emergency this amount would only be used to pay for basic expenses.  Mortgages, car payments, food and basic utilities should be included in this calculation.  Your Netflix membership and cable bill could be canceled or put on hold in a pinch.  To the savvy investor $15,000 may sound like an exorbitant amount of cash to keep on the sidelines, but just imagine the peace you would feel knowing you had $15,000, or even $20,000, just sitting there in case of emergency.

 
photo by chrisbb

This is a guest post from The Happy Rock @ The Happy Rock, a personal finance blog dedicated to changing our behaviors to change our wealth.  You can subscribe to his feed here.

Most financial plans include some amount of cash savings to help get you through life’s unexpected events.  2 of the first three steps of the Dave Ramsey baby steps revolve around the emergency fund.   I know Frugal Dad has already covered what an emergency fund is, but I want to share what having an emergency fund has meant to me.

First let me share a little bit about my background.  My wife and I followed a slightly modified Dave Ramsey plan as we got rid of $70,000 in 4 years.   We had the initial $1,000 in the bank quickly and luckily never had to use it during our debt elimination.  Building up 3-6 months expenses took what seemed like an eternity, but since that time we have never looked back.

Now that you know relevant history, let’s explore seven things that our $1,000 and fully funded emergency funds ‘bought’ us:

1. Protection - First and foremost a cash savings is designed to be a buffer so that you can avoid debt when bad/unexpected circumstances show up at your door step.  With a cash savings you can avoid using the credit card for things like unexpected car or home repairs.  It can tide you over in the event of a job loss or income shortage.  Frugal Dad just recently shared about the importance of his emergency fund and how it protected them against a few unexpected expenses.  We were lucky, since the only time we had to dip into our emergency fund was when our second adoption happened quicker than we had planned, but we were able to quickly replenish it since we had a hefty cash flow from not having any debt.
2. Success - The idea behind the $1,000 mini-emergency fund that Dave Ramsey recommends is not only to create a little barrier to keep you out of debt, but also to get your positive energy flowing by being successful at saving.  When people realize that they can meet a small goal and be successful they begin to have faith that they can conquer larger goals.   I can also attest that getting a full 6 months expenses in the bank was the point at which I finally felt my finances were a success.
3. Lower Stress - It is amazing how much having protection that will carry you through most of life’s curve balls reduces the amount of energy that you spend thinking about your finances.  Worry starts to melt away and is replaced by a sense of security.
4. Freedom - With 6 months expenses in the bank a whole new realm of possibilities opens up.  You can now consider taking a leap and quitting the job that you hate or by cutting back some hours to pursue a side business or volunteering.  You have the freedom to invest more for the future without sacrificing the present.  Things that were impossible just months or years earlier now seem a lot more feasible after accomplishing a fully funded emergency fund.   Your financial system now frees you to focus your energy on things that are more important than money.
5. Motivation - The motivation is driven by the removal of stress and the reclaimed mental energy.  You can now turn your attention towards goals and opportunities that excite you, rather than being caught up in just making sure your financial house of cards doesn’t crumble.
6. Giving - Instead of feeling like you need to cling to ever dollar, you can begin to loosen your grip on those precious dollar bills.  Instead of clenched fists, you can great life with open hands ready to accept what comes your way and give back to those around you.
7. Passive Income - Finally, 3-4% interest on 6 months expenses isn’t going to help you quite your day job, but there is something quite satisfying about collecting almost $400 a year in passive income that adds another layer of satisfaction to having an emergency fund.

I can honestly attest that having a fully funded emergency fund marked an amazing switch in focus for my life.   I suspect those of us with fully funded emergency funds have had similar experiences. Hopefully those that are just getting started and those that are in the midst of their debt elimination can use this list as inspiration.  It really is as great as it sounds.