Photo courtesy of Maurice

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.

photo by Faeryan

Regardless of which side of the fence you sit on when it comes to how to implement a debt snowball, there is one thing we can all agree on–it is highly motivating to see debt balances falling.  So much so that when you have to put the snowball on ice it can be a bit demoralizing.

Murphy Has Set Up Shop at Our House

Over the weekend I mentioned all the things that have gone wrong over the past few weeks, and the various hits to our emergency fund.  Fortunately, the emergency fund was there to cover these expenses so we didn’t have to turn to credit cards, or try to cash flow them by completely rearranging our budget.  Unfortunately, we will now have to put debt repayment on the back burner while we rebuild our emergency fund.  I’m just not comfortable living with a reduced emergency fund and throwing every extra penny at debt.  With a reduced emergency fund the next rash of emergencies could deplete our savings entirely and force us to once again turn to credit cards.

Here are some of the steps we’ll use over the next few weeks to get the emergency fund back up to our $3,000 goal:

1. Pay only minimum payments on credit cards. Instead of piling anything extra on debt, we’ll be diverting it to savings in the short term.  After attacking debt so aggressively the last few months this will prove difficult.
2. Snowflake any extra money into savings rather than towards debt.  I normally take any found money (snowflakes) and apply them directly to the debt snowball as they are received to boost the amount going towards debt repayment each month.  Now, I’ll pile up those snowflakes in savings.
3. When the emergency fund balance reaches $3,000 we will turn our attention back to our debt reduction plan.  I’m not sure how long it will take to get the emergency fund back to a fully funded status.  Thankfully, we didn’t have to dip too far, and I have a couple payments due for some freelance writing work I’ve completed recently–that should help.

Flipping the Switch

I believe this exercise is actually good for us (not that I want more visits from Murphy).  When we are finally debt free we will need to flip the mental switch to savings rather than debt repayment, without increasing our spending.  Sure, we might add back a few small expenses that we’ve eliminated to become debt free, but for the most part our budget won’t change much.  Shifting from debt paying to savings mode and back again should help us get comfortable with both styles of living on less than we make.

photo by pointnshoot

It has been a rough month in our household.  It all started when my wife took a spill in a parking lot after rolling her ankle.  She severely sprained her ankle, and even did some ligament damage.  She was prescribed crutches for a couple days, and an AirCast for 4-6 weeks.  Fortunately, it appears she avoided the need for surgery, but we won’t know for sure until the boot comes off.  The medical bills for x-rays, the ER visit, the orthopedic follow up, the AirCast, and the crutches are starting to roll in.

When It Rains, It Pours

A few days after her fall, on the morning of July 4th, we awoke to an unusually hot house and a broken air conditioner.  It was a particularly hot day, and by noon it was already hovering near 85 inside our house.  Our service guy discovered a burned out fan motor on the unit outside our home and put on a temporary replacement.  Fortunately, the motor was still under warrantly (barely), but we still owed $125 for the labor.

Over the weekend I was mowing our lawn and the mower died about half way through the job.  The nearest service center is about twenty miles away, so I asked if they could come pick it up.  They said, “Sure, for a $150 fee!”  Of course I said no, and immediately thought about the stuff I had loaded on a trailer that I could use to transport the mower.  When it rains it pours.

Our home computer crashed last week.  I guess it is expected since the desktop is now close to eight years old, which is an eternity in PC years.  While downloading email the system froze, and upon restart it would not boot up, citing a missing or corrupted windows file as the culprit.  I did manage to salvage my wife’s pictures she had transferred from a digital camera, but not backed up (lesson learned).  When I get some time I plan on wiping the hard drive and reloading the operating system to see if we can’t squeeze a little more life out of it.  However, we will definitely be backing up anything we save to CDs and will probably keep an eye out for any good deals on a new PC in the interim.

The real icing on the cake came last Monday evening.  My wife had prepared a new dish that we were all looking forward to trying. We had gathered in the kitchen and the kids were telling me about their day when we heard a loud popping sound.  We looked at the oven and the inside glass panel in the oven door had shattered, spraying glass all over our meal and rendering the oven unusable. We let it cool down, cleaned up the mess, and headed to Subway for dinner.

Moral of the Story

There isn’t one.  I just wanted to vent.  No, I’m kidding.  The moral of the story is that all of these things would have been major, budget-busting events just a couple years ago.  However, with our emergency fund in place at ING Direct these strings of bad luck are just minor inconveniences.  Well, some are more inconvenient than others, but you know what I mean.  Having an emergency fund in place allows us to focus on making the situation right, rather than worrying about how we are going to pay for it.

I’m more convinced than ever that having a solid emergency fund in place should be priority one in any good financial plan.  Our mission over the next two or three paychecks will be to replenish the funds we’ve used over the last few weeks, and hope nothing else breaks for a while.

In response to one of my ING Direct reviews and a discussion on emergency funds James asked a question in the comments, “How close should they be?” That’s a great question, and one I have asked myself since turning to online banking. A few online banks offer ATM card access, and a couple even reimburse ATM fees for withdrawals. However, the ING Direct Orange Savings account offers no such features. Transfers are handled online and take two or three business days to show up in either account. This presents a dilemma - what if I need access to my emergency savings today?

Start Local and Expand Later

We have decided to save $1,000 locally in a bank savings account, and anything we save above that we transfer to ING. The interest on a bank savings account these days isn’t enough to buy my kid a pack of chewing gum, but I’m more concerned with accessibility. Keeping a portion of your emergency fund locally provides quick access to at least the first $1,000 of our emergency fund in the event of a real emergency. This would be enough to cover the initial costs for most repairs, out-of-pocket medical care, etc. The remaining emergency funds would show up a couple days later for larger emergencies that required more than this “local emergency fund” could cover.

Select a Comfortable Level for You and Yours

I mentioned that I am not overly concerned with the interest rate on this local emergency fund. However, I do want to maximize any interest income potential with the larger, online emergency fund, so it makes sense to limit our local emergency savings fund to a specific amount. This minimum amount should be decided on by you and your family, not based on a recommendation from someone else. Around $1,000 works well for our family, but it may or may not work for yours, and that is fine. In uncertain times it makes sense to save a little more. When your checking account has a healthy balance, perhaps you could save a little less. The point is to have something liquid, easily accessible, and local so you can avoid turning to credit cards in an emergency.

Couldn’t I Just Use an Emergency-Only Credit Card?

Sure, assuming you have the discipline to identify real emergencies, and pay off the bill using emergency fund savings when the bill arrives. I have fallen into the trap of using a credit card to finance an emergency with the self-promise to pay it off when I get the bill. The bill arrives, and I am reluctant to use such a large chunk of savings to pay if off in one payment, so I rationalize that I will pay it off over time since the credit card’s interest rate is low, or because I like having the safety net of cash in reserve. Now I am stuck with a revolving balance that with interest is causing that emergency to become more and more expensive with each billing cycle. The only way to get off the never-ending hamster wheel of debt is to stop using credit cards and loans to finance life events. Create a local emergency fund to catch the small stuff, and a larger, fully-funded emergency fund online to save for life’s curveballs.