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 one of the top online banks (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.

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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 at our online bank. 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.

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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.

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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.

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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.

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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.

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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 Direct. 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.

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Think of your emergency as a personal line of credit. It might even help to sign up for an account that offers a debit card. I keep my emergency fund debit card in my wallet with one of those ATM card slips that says, “Break only in emergency!” When Murphy strikes I use that debit card to tap my emergency fund rather than turning to a credit card.

Hang on to your oldest, no-fee credit card until you have established several months of savings. By keeping one credit card with available credit you still have a backstop should you have the unfortunate luck of getting hit by two emergencies in the same month. Be sure that the emergencies are real emergencies – clearance items at your favorite store do not qualify.

Emergency funds should remain in a highly liquid account. The majority of your emergency funds should be socked away in a high-interest savings vehicle, like a savings account with a top online bank. We also keep a local, smaller emergency fund in an interest-bearing checking account (with debit card access). I could get a higher rate of return on this smaller amount elsewhere, but I have discovered that the higher the rate of return on my money the more pressure I feel not to touch it. This is especially true of holding an emergency fund in stocks or mutual funds. If the market is up, I don’t want to cash out because it might go higher. If the market is down, I don’t want to cash out until it goes back up again. Best to simply keep the emergency fund in easily accessible cash.

Make rebuilding your emergency fund a top priority after each expenditure. If your car died last week and the repair bill topped out at $600 you should quickly find a way to refund that $600 back to your emergency fund. Stop paying extra on your debts until that $600 has been replenished – minimum payments only. Take some extra overtime next week. Round up some old books and DVDs and sell them on EBay. The point is to make rebuilding that emergency fund your number one priority. Having that plan in place before the emergency will make it easier to swallow the $600 hit to your emergency fund, because you know it will be quickly replenished.

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Increase your cash position. Entering a recession proves to be a good time to increase your cash position. Not only does a healthy emergency fund help pave over short-term bumps in your household finances, it also allows you the opportunity to find some excellent deals in the investment and real estate markets. Institutional investors make a lot of money buying on the way down, and the same rules apply to the individual investor. If you are fully invested, or fully leveraged, you probably lack the cash to take advantage of these deals.

Consider allocating more investments to international markets. If the U.S. recession deepens it will have an impact on other markets because we are in a global economy. However, the losses may not be as severe, and other external factors may help international markets continue to grow even in a U.S. downturn. To hedge against deep domestic losses it’s always advisable to keep a percentage of your investments in foreign stocks. Entering a recession it might make sense to boost that allocation percentage in an international fund and reduce domestic investments, in the short term.

Get smart – learn a new skill or add to your current skills set to make yourself more “layoff proof.” True recessions are usually accompanied by massive layoffs. In this particular recession, the financial services industry could be hardest hit. Now would be a good time to consider taking that online class or pursuing some cross-training to make yourself more valuable to your organization. It might make the difference between getting a pink slip or getting a raise.

No Chicken Little, the sky isn’t falling, but just in case. Recessions tend to bring out a lot of doom-and-gloom commentary. I personally have faith in the U.S. economy and do not think we are headed into another depression. Still, it is a good idea to review your family’s emergency plan. Stock up on basic necessities, including non-perishable foods and a few gallons of water. Instead of running out and buying these things all at once, just pick up a few items along with your normal, weekly grocery trip and over time add to your stockpile. In our current environment this is something we should already have in place in the event of a disaster (natural or otherwise), and news of a recession serves as a reminder.

Surviving the recession and need to save money at the grocery store?  You can get coupons here. We have a large selection of printable coupons you can choose from. You can get printable grocery coupons for any type of item you need from a grocery store.

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So, about 10:00 last night we embarked on a refrigerator cleanup throwing out most non-essentials and older leftovers.  I ran to the store to grab a few bags of ice and we transferred condiments, drinks and a few packaged foods over to a cooler.  Now we’ll wait it out for another visit from a repair man.  We aren’t paying another $60 fee, either.

Just when I thought things couldn’t get any worse I awaken this morning to discover a [tag]credit card[/tag] payment posted a day early, and resulted in five non-sufficient funds charges to my [tag]checking account[/tag].  Yes, five – for a total of $175!  I almost fell out of the chair.  I plan to visit my bank during lunch, hat in hand, and beg for mercy. I feel I owe at least one for my calendar error, but FIVE?

Both of these incidents remind me of the importance of a solid [tag]emergency fund[/tag].  The refrigerator dying and my banking screw-up have the potential to be a real budget-buster this month.  Assuming I have to pay for both Murphy attacks I can always move some money over from my emergency fund, and then replenish it when things return to normal.  I have to admit these two items have knocked the wind out of me, but without that padding I would be a lot more upset.

Buy appliance parts online and save.

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