What stands between you and major financial trouble?
Hopefully, it’s not just a credit card, a HELOC or some other form of debt that you killed in Step 4. And if you have any significant issues, that starter emergency fund we set up back in Step 3 is not going to go very far.
Now that you’ve taken care of the symptoms of your past financial troubles by paying off all non-mortgage debts, it’s time to prepare for those inevitable rocky times that lay ahead.
After you complete Step 5, you’ll be ready to face those costly home repairs, unexpected medical bills and periods of unemployment.
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You won’t like it when an emergency strikes, but you’ll be prepared and ready to cover the financial impacts without resorting to debt.
Let’s build our full emergency fund!
How Much Should We Save?
As a general rule, most families should have approximately 3-6 months worth of expenses in an emergency fund. It’s important to understand that this not 3-6 months of income, and it’s not inclusive of all the money you spend in a typical, non-emergency month.
To calculate an appropriate amount, go through that budget we put together in Step 1 and decide on a line-by-line basis whether each expense is something that you’d need to cover if you were faced with unemployment. Once you have that monthly “bare-bones budget” amount, multiply it by a factor of 3-6 and you have your goal.
The 3-6 month time-frame will allow most people to regain gainful employment if they are faced with a job loss. While unemployment isn’t the only potential emergency out there, it’s certainly a relevant threat for most people and this amount of savings will also cover most reasonable “expense” emergencies that you may face.
So, should you save 3 months, 6 months or something in between? Well, your personal amount should be based on your exposure to risk as well as your risk tolerance.
If you have two stable jobs and a fairly “calm” life with little volatility in your expenses, then 3 months is probably sufficient as long as that amount makes you comfortable. On the other hand, if you are a one-income family with lots of little kids around and you feel like trouble is always lurking, you should shoot for 6 months of expenses. At the end of the day, it’s a judgment call.
Where Should We Save It?
While our starter emergency fund was kept close to home at a local bank for super-fast access, our full emergency fund needs to work a little harder for us. In most cases, we’re talking about many thousands of dollars (often tens of thousands), and there is decent money to be made through interest earnings.
Just to be clear, you should not be investing this money and putting it in any real risk. Your emergency fund is effectively an insurance policy you’re keeping between yourself and financial ruin. We’ll get into investing in Step 6, but we will not be using our emergency fund for those efforts.
That said, there are options out there that pay better rates than your local bank, offer reasonably fast access to your money and keep it safe. My personal favorite is an ING Direct Savings Account. ING is a great company who pays strong, market interest rates on your money while keeping it FDIC insured and very accessible.
If you decide to open an ING account, please be sure to send me your first name and email address using the Contact form. When you do, I’ll send you a link that you can use to open a new account and get an instant $25 bonus for free! And I’ll get $10 for referring you, so it’s a great deal for everyone!
When Should We Use It & What Happens If We Do?
Once you have a nice emergency fund stashed away, you may wonder just when you are supposed to take money out of it. Well, you don’t want to tap into your emergency money unless you have an actual emergency that you couldn’t foresee.
For example, regular home maintenance should be part of your budget and not something you need to take from your emergency fund to pay for. And you know your car insurance is due each year, so that’s not a good use of these funds.
On the other hand, you can’t plan for a broken leg or a job loss, so when you have a true emergency, tap into your account and feel good that you are prepared.
Once you get your full emergency fund in place, you’ll be moving onto investing, paying off your mortgage and meeting some other financial goals. If (or when) you do encounter trouble and you have to take money from your account, you’ll need to pause these other goals temporarily and redirect your “extra” money each month back into building your emergency fund until it’s back to your comfortable level.
Without question, this full emergency fund requires a lot of money to complete, but if you keep the same intensity that took you through paying off your debts and redirect that “debt snowball” money each month to your savings, you can absolutely do this.
Once we completed this step, we felt a true sense of financial peace in our family. We’ve needed it several times and, although spending lots of unexpected money is never fun, it’s great to know that you are financially ready to face most of the nasty stuff that life will throw your way!
Bring peace to your marriage by building your own full emergency fund.
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Dustin, once you get to Step #5, should you put the $1000 emergency fund into the bigger emergency fund, or keep them separate?
Hey Stephanie, the starter emergency fund “counts” toward your full fund total, but I recommend keeping the starter amount in your local bank for super-fast access. So, if you have a $10,000 full emergency fund, you might want to keep $1,000 locally and put the other $9,000 in an account like ING. Hope that helps!
This is a great explanation of the emergency fund. One of the most frequent question I hear is how much is ideal, and you answered it perfectly by going through both obligations and home situation.
The one point that I wish had been driven home a bit more when I was getting out of debt and building my emergency fund was that you HAVE to treat your lack of emergency fund as another debt and fund it just as aggressively.
When I finished my debt there was a sense of ‘I’m free – now I can do all the stuff I wanted to’, and THEN the realization that, no, actually, you still have to take care of this fund.
That said, having a fully funded one takes SO MUCH stress out of life’s problems that it was completely worth it.
I couldn’t agree more, Evan. We felt the exact same way after getting all of our debts paid off and feeling like we “deserved” to start buying all of the things we had put off right away. While it can be a bit painful to take the extra time to save up the emergency fund, it is TOTALLY worth it when you experience the freedom and security it provides.