How to build an emergency fund
A lot of the standard advice on this topic doesn't work for many families. Here's another approach.
This post comes from partner blog The Dough Roller.
Recently I wrote about how my wife and I paid off a lot of debt in less than five years. An important part of getting out of debt for us was an emergency fund. A lot has been written about the importance of saving for a rainy day. But most of what you'll read on the subject is either unrealistic or just not helpful.
For example, a common refrain is that you should save three to six months of income for emergencies. While this rule of thumb is fine as far as it goes, it can take some families years to reach this goal. And while they are trying to save, do they ignore paying off debt or saving for retirement? And by the way, is three months or six months best? Post continues after video.
Dave Ramsey tried to address these issues. In his seven "baby steps," he advises folks to save $1,000 in an emergency fund and then tackle debt with "gazelle intensity." As with the three- to six-month rule, Dave's approach may be fine for some. But it raises at least two questions: (1) Why $1,000? I think most families need a lot more, and (2) Why does it have to be all or nothing? Why can't you save for a rainy day, pay down debt, and save for retirement all at the same time?
And that brings me to the approach my wife and I followed. I'll warn you in advance that we took steps that were far from conventional. But our approach underscores the fact that one-size-fits-all just doesn't work when it comes to finances. So let's walk through our approach.
How much to save for emergencies
How much to save for a rainy day is probably the most frequently asked question. Dave Ramsey says to save $1,000 and then start tackling debt. If your monthly budget is $10,000, savings of $1,000 would represent a three-day emergency fund, which is not exactly the kind of thing that will help you sleep at night.
Rather than pretending that there is a single best answer to this question, here are the factors to consider when deciding what's best for you:
- The consequences of a financial catastrophe: If you are single, live in an apartment and have a supportive family, a job loss may mean moving back in with Mom and Dad. In contrast, if you have a family of four and little family support, a financial crisis may mean looking for a homeless shelter. The greater the risk, the more you should save for emergencies.
- The interest rates on your debt: If you are stuck with credit card debt at 30%, you'll want to start paying it down as quickly as possible. As a result, a smaller emergency fund may be appropriate. If your only debt is at a much lower rate (e.g., a car loan or home equity line), the urgency to pay down your debt won't be the same.
- Your access to cash: If you have a line of credit or retirement savings you can tap in an emergency, then a large rainy day fund may not be critical. In our case, we went without any savings for a time because of our access to a line of credit and retirement savings. MSN Money's Liz Weston recommended this approach in an interesting article about the $0 emergency fund.
- Your risk of job loss: While anything can happen, some of us are more at risk of losing our jobs than others. There’s no rule of thumb here; you have to assess your situation. But if you think a job loss is unlikely, a smaller emergency fund may be appropriate.
- Your sources of income: If you have multiple sources of income (e.g., a two-income family), it's worth considering whether you can get by with smaller savings while you pay off debt. The point is that it's probably unlikely, although not impossible, that you would both lose your job.
- Your employer's retirement plan: If you have an employer that matches 401k contributions, you'll want to take advantage of the match as quickly as possible. This could mean building up your savings at a slower pace, all other things being equal.
With these factors in mind, here's the approach we like best:
- Save one month of expenses. As a first step, save one month worth of living expenses before tackling any debt or investing.
- Begin paying extra on debt. Once you have a month of expenses saved up, split your extra money between paying down debt and building your emergency fund.
- Take advantage of an employer match. If your employer matches a portion of your 401k contributions, build up to investing enough to take advantage of the match. At one point, we were saving, investing, and paying off debt at the same time.
- Supercharge debt pay-down. Once you've reached your emergency fund goal, direct your extra cash to paying off debt.
- Customize your solution. Be mindful of the factors listed above to tailor your approach to your specific circumstances. If you have debt at 30%, that will take priority over just about anything else, for example.
Where to stash your emergency fund
There are a couple of good options, and they depend once again on your specific circumstances. If you are just starting to build your emergency fund, I'd stick with a high interest savings account. Once you've built up a cushion, you can look to get some higher rates with CDs. I like the Ally Bank long-term certificates of deposit because they have relatively low penalties for early withdrawal.
As a related matter, you can also create a CD ladder to take advantage of high rates while maintaining access to your funds. With current rates at historically low levels, however, sticking with a savings account is probably the best option.
Finally, as your investments grow and you eliminate debt, you may find little need to keep a lot of money in cash. Particularly with the low interest rates we see today, you may want to consider low-risk bond funds as an alternative to a savings account. Given the likelihood that rates will eventually rise, I'd stick with short-duration funds so that a rise in rates won't have a major effect on the price of the fund.
More on The Dough Roller and MSN Money:
Dave Ramsey doesn't push 3-6 months of income. He pushes 3-6 months of living expenses. And once you've paid off all the consumer debt, the amount you need to live on drops dramatically. That's one of the reasons he says pay down debt before fully funding the emergency fund. Another reason is the power of focusing on one thing at a time. If all extra money is going toward paying debt you pay the debt faster. Don't knock. Dave. His plan WORKS!!
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