We always say you should set up a budget for financial emergencies, but readers ask us all the time what that really means. Today, we've got your answer:
Situation #1: It’s a friend’s wedding, your ex-boyfriend will be there with his new girlfriend and you need an absolutely perfect dress to wear.
Situation #2: A once-in-a-lifetime opportunity presents itself for you to go on a trip to Tahiti … but you haven’t exactly been saving up for a vacation like this.
Situation #3: It’s your best friend’s 30th birthday party, and a mutual friend has suggested that a group of you put in for a present that’s just a little more expensive than you had been planning on (even though you’re only paying a fifth of it).
Though these three situations might not be life-or-death emergencies, they’re still emergencies, right? Well, not really … at least not where your “emergency fund” is concerned.
Still, while you know that a killer pair of post-breakup stilettos isn't quite why you've been socking away money, it can be tempting to dip into your stash when something comes up that’s not in your budget.
RELATED: The Basics - How to Set Up a Budget
At LearnVest, you'll hear us talk about your emergency fund a lot, and that's because it's the best way to protect yourself in a true monetary crisis. To understand what’s really considered a financial emergency, how much you need to save in an emergency fund and how to prepare for those big expenses that always seem to sneak up unannounced, we asked Brandie Farnam, a LearnVest financial expert and CFP®. Check out her answers:
What’s an emergency fund, anyway?
An ideal emergency fund is at least six months of net income stored in a savings account. LearnVest advises you to have at least six months’ saved, but if your job is unstable or you work as a freelancer and have an irregular income, it’s probably best to have more than that socked away.
When are you allowed to dip into an emergency fund?
An emergency fund should really be used only in the five following situations:
- You’ve lost your job, and need to continue paying rent, bills and other living expenses
- You have a medical or dental emergency
- Your car breaks down, and is your primary form of transportation
- You have emergency home expenses—i.e., your A/C breaks down in 100+ F weather, your roof is leaking, your basement is flooded, your toilet is overflowing, etc.
- You have bereavement-related expenses, like travel costs for a family funeral
If you don't have an emergency fund saved, and one of these five types of emergencies arises, you'd likely be tempted to use a credit card to handle it, leading you into credit card debt. In fact, medical expenses are the leading contributor to credit card debt, with low- to moderate-income households averaging $1,678 in credit card debt due to out-of-pocket medical expenses.
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What's worse? Paying for emergency expenses on your credit card, if you don't pay off your bill immediately, will cost you more, as you'll rack up interest payments as you try to dig yourself out of debt. Having an emergency fund saved will not only save you more money in the long run, due to the fact that you won't be paying interest on your expenses, it will give you peace of mind, knowing that you'll be able to handle whatever life throws at you (and there will be a curveball one day--trust us).
Doesn't anything else count? What about near-emergencies, like property taxes, freelance taxes or insurance payments?
Property taxes, along with taxes for freelance work, renter’s insurance and homeowner’s insurance—not to mention unexpected taxes come April—are considered “irregular expenses.” They can seem like an emergency—especially if you haven’t saved up for them—because you can’t not pay your taxes or your insurance bills.
That said, dipping into your emergency fund for anything besides the five situations detailed above is a really bad habit—and it means you won’t have enough money should a real emergency pop up. Here’s what you should do instead:
- Estimate how much money you’ll need to pay for these one-off or irregular expenses based on how much you had to pay last year.
- Divide this estimated number by 12—this amount will be how much you should put away each month. In terms of the 50/20/30 rule (see below for a full explanation), you should think of this money as coming from your 30%, or your lifestyle choices.
- Automate your savings so the amount you calculated in step #2 is deducted each month and put it into a savings account separate from your emergency fund.
If you don’t have an emergency fund, what's the best way to build one?
LearnVest advises you to split your monthly budget using the 50/20/30 rule:
- 50% or less of your take-home pay should go to essentials like rent, groceries, transportation to and from work, and utilities
- 30% or less should go to lifestyle choices like shopping, entertainment, going out with friends, etc.
- 20% or more should go to priorities, like saving an emergency fund, saving for retirement and paying off debts (credit cards, student loans, etc.)
Here’s how you should divvy up that 20% to your different priorities:
- Retirement: If your employer matches your 401(k) contributions, pay the minimum amount necessary to get the full company match. If there's no matching program, save at least 1% of your take-home pay in a 401(k), or start saving $50 a month in a Roth IRA.
- If you have credit card debt: Split the remaining amount equally between paying off your credit card debt and stocking up your emergency savings, until you have at least six months saved in your emergency fund. If you don't have credit card debt: Contribute the remaining amount to your emergency fund, until you have at least six months saved.
- Every six months, schedule a 1% increase in your retirement savings contribution if you're putting it in a 401(k) (or a $50 increase if you're saving in a Roth IRA), even while you continue to contribute to these other goals.
What should you do if you already have six months saved in your emergency fund, or are nearing that point?
If you have six months saved in your emergency fund, stable work and a regular income, and no debts ...
Congrats! Now you can concentrate on tackling other priorities and goals. Consider upping your retirement savings and trying to max out a Roth IRA in addition to your 401(k) contributions. You can also create and start funding savings accounts to pay for other goals like travel, a down payment on a home or a future wedding.
If you have six months saved but are in an unstable profession ...
Consider continuing to fund your emergency fund until it holds nine or more months of living expenses, while still saving for retirement and paying off any loans or debts you might have.
If you have six months saved but have credit card debts or loans …
Now you can start paying down your credit card debts more quickly or contribute more to paying off your student loans. This will help improve your credit score, which will help save you a lot of money in the long run. (Find out why here.)
Trust us: While it might seem tempting to spend "priority" dollars that should be going to emergency savings or your 401(k) on "priorities" like that trip to Aruba with the girls or a bag that will last for seasons, you'll feel much better knowing you can handle any real emergency that comes your way.