Emergencies happen and you need to be prepared. If you were to have the transmission go out on your car, how would you pay for it? Would you put it on a credit card? If the emergency cost you $2,000, how long would it take you to pay off that card?
According to CreditCards.com, the average credit card rate in the United States is 14.97%. That can make having an emergency more stressful, knowing that it could potentially cost you more if you can’t pay the card off right away.
What is the solution then?
Definition of an Emergency Fund
An emergency fund is an savings account that you put money in and just let it sit there and its sole purpose to pay for emergencies that arise.
It is not a “let’s take a trip to California” fund, it is more of an “oh no, my car just broke down” fund.
What constitutes an emergency?
Anything that happens that is not in the budget and that needs to be addressed would be considered an emergency. For example, when Kim and I first got married, we had two condos. One was a rental and the other one we lived in.
Within the same year, we had both hot water tanks go out which cost us over $1,000 to fix.
Since we had an Emergency Fund, we were able to pay cash right away to have them both fixed and didn’t have the stress of figuring out where we would get the money.
How much is enough to keep in your Emergency Fund?
It depends on where you are with your finances. If you have debt, I would say $500 would be good and is what I call a Starter Emergency Fund. If you make more than $40,000 per year, you can increase yours to $1,000.
Then pay off all of your debt, smallest to largest (see my previous post on how we paid off $52,000 in debt in 18 months). If you are debt-free except for your house, you should have a minimum of 3 months worth of living expenses.
For instance, if you spend $2,500 per month, then you should have $7,500 sitting in an interest bearing savings account.
Don’t people say to have 3-6 months worth of expenses?
Yes, but I like to have smaller attainable goals. Ask yourself, how many people do you know that even have 3 months of expenses in an Emergency Fund? The goal is to have cash reserves to cover most emergencies that come your way.
Now, if you foresee a job loss or know of potential expenses that could exceed 3 months, then by all means, increase the amount that you set aside.
Where do you keep an Emergency Fund?
The best place to keep the money is in a high yield money market account.
There are several options out there, but if you are looking for a place worth checking out, read my review of CIT Bank where we currently keep our emergency fund.
Once the Emergency Fund is tapped out, then what do you do?
Fill it back up. Take the surplus or the money you have left over after paying all of your bills and then begin replenishing your account until it is full again.
If you are living paycheck to paycheck, like most broke people, and feel like you don’t have any surplus, check out ways to earn extra cash or ways to trim your budget.
How people normally pay for emergencies
Have you ever had your car break down? Have you ever had a water heater burst? What about an Air Conditioner that just stopped working in the middle of summer? If you said ‘Yes’ to any of these, you are not alone.
I think you would be hard pressed to find somebody that has not had some sort of emergency situation happen to them in the past 5 years.
This being said, there are many ways one can approach these situations from a financial perspective.
A Credit Card
According to a recent article at Bankrate.com, the average annual interest rate of a NEW credit card is 12.4%. Also, according to IndexCreditCards.com, the average household carries $7,861 in revolving credit card Debt.
This tells me that many people are using a credit card to cover their emergencies and that they are not paying it off every month. This, in turn, means that people are paying high-interest rates just to cover life’s curve balls that are thrown at them.
Take Out a Loan
According to MSN Money, The average personal loan rate is 12.52%.This would put us in the same boat as if we used a credit card, in fact, we would even pay a little more in interest going this route.
Pay cash for it
I don’t know about you, but I have never paid interest on using cash. In fact, if you have a good reserve of cash in the bank you can make money on it while it just sits there.
This seems to be the best course of action, put money in your pocket instead of another person’s pocket.
This being said, you are probably wondering, “That is great in theory, but how do I get enough cash in the bank to cover an emergency if it happens?”
3 Ways to Build Your Emergency Fund
1. Sell stuff on Ebay and Craigslist
We were able to sell a ton of stuff online to get money for our emergency fund. You would be amazed at what kind of money you can get from selling Books, Movies, and Clothes that you don’t need or use anymore.
2. Cut Your Expenses
We canceled our cable, stopped eating out as much, and changed some of our entertainment habits.
3. Combine Expenses
When we first got married, we had separate accounts for almost everything. We then combined our cell phones, car insurance, and life insurance providers which drastically reduced our expenses
A fully funded Emergency Savings Fund should have 3-6 months expenses, but you’ve got to start somewhere.
Get $1000 in the bank and then come back and visit my next blog on the Debt Snowball made famous by Dave Ramsey.