What goes in an emergency fund? Money. Cash. The thing is, we don't know what an emergency will look like so it is important that your emergency fund can cover all sorts of weird situations. Cash is king, as they say, and barring the end of the world, cash should still be good in your local jurisdiction. It may still even be good after the end of the world if nobody is quite sure what else to do.
Where do you put this cash? Lets think about what an emergency might look like. A fire. A devastating robbery. An accident whilst hiking in the Himalayas. You want cash, but don't leave it in your wallet, mattress or in a jar underneath a tree that only you know where it is. If it were under a tree that only you knew where it was, it would be rather difficult to pay a hospital bill in Nepal. Can you imagine trying to explain to the billing department there how you planned on satisfying the bill? Even more nightmarish is if you were hiking without a permit - that $11,000 fine would not be satisfied by the laughter you would evoke from the friendly park rangers.
Put the cash in a bank account. I generally advise having an online savings account that is reasonably out of reach, sight and mind. You can probably find one that does not charge fees as long as you maintain a certain balance. Set it up so that you can transfer money back and forth from your checking account and go ahead and set it to auto deposit until you have built up a reliable reserve.
I recommend online bank accounts for a few reasons. You can typically get lower fees and a better possibility of an interest rate online. Also this means your money will be accessible wherever you are. If this is separate from your other banking activity, this keeps it out of sight and out of mind - exactly where an emergency account should be.
How much do you need to put in there? This is the trick. Start with $1,000. Why? It is a nice number. It has several digits and if you're just getting started with this frightening world of imagining the worst, it is a comfortably round place to be. From there, stash 3-6 months of living expenses. Think about all of your must pay costs - mortgage/rent, utilities, loans, food and a modicum of entertainment. If you are particularly worried, stretch that out to 12 months. Once you have three months expenses put aside, however, breathe a little sigh of relief and bake yourself a cookie or five dozen.
Are we done yet? No, not quite. Losing your job for economic or motivational reasons is one thing. If that happened, the aforementioned emergency account would tide you over for 3-6 months. You would have time to figure out how to make that stretch a little longer too. But emergencies can get much worse. You can have a car wreck, a tornado could hit your house or you and your family could come down with a mysterious, new and expensive disease. For these sorts of things, you'll need to have cash to cover insurance deductibles and out of pocket medical expenses. Add up these and add them to your monthly expense sum.
Say you have living expenses of $2,000/mo with $1,000 deductible on your home and $500 on your car insurance plus a modest $2,500 deductible on your health insurance. To cover yourself for plowing your own car into the side of your house in the sort of way that hospitalized you for 5 months, you would need:
- $2,000 x 5 = $10,000 for the bills that keep rolling in the door.
- $500 to get the car fixed and ready to go upon your release.
- $1,000 to keep your house from collapsing further.
- $2,500 to stay pay the good people keeping you alive.
- Or a total of $14,000.
- Add in another $2,000 to get yourself back on your feet one you get out and you need $16,000.
Does it have to be this way? This much money? In an account earning next to nothing?
That much cash sitting in an account can be very boring when it does not earn any interest. It can also be hard to forget about if you are tempted to spend elsewhere. You may get antsy about the returns you are missing out on elsewhere. Remember that cash has value besides just the interest that it earns. There is value in that money being readily available and value in the assurance that it will be there.
That is a very large amount of money for most people. Emergencies are, by their nature, rare. It is unlikely that you will need this money. Picture the total figure as a goal, the most conservative, totally covered amount. You're not going to start day one with all of this saved up. You should keep this number in mind as a goal, a way to restrain yourself from spending too much elsewhere.
Here are some other financial accounts that can help you in a real emergency.
A Health Savings Account. If you have a high deductible health insurance plan, you can have an HSA, or health savings account. Money going into the account reduces your taxable income, and money coming out is not taxed so long as you spend it on medical expenses. For 2017, you can set up a health savings account that allows you to contribute up to $3,400 for an individual HSA or $6,750 for a family HSA account.
Investment Accounts. Investment accounts have money in them. You can use this money! The tax consequences will depend on what type of account it is. Typically your taxes and penalties will be highest with a traditional, deferred income account like an IRA or 401(k). A taxable investment account will have the most flexibility but a Roth IRA may not have tax consequences for withdrawals depending on your age, what the expense is and how long you have money in the account. Investment accounts are best for longer term, predictable expenses, so they may not be ideal for an emergency situation. This could be an interesting option if you had plenty of money to invest but did not want to have your cash doing nothing in a savings account.
Credit Cards. This one is tricky because an emergency could very well cut off your access to credit, or could have stemmed from poor usage of credit in the first place. Assuming that you have managed your credit well, and modern commerce is still going on in the world around you, you can probably still use your credit cards to tide yourself over when money is tight. Ultimately, in an emergency you should be looking to cut your expenses, so credit card spending should be considered a last resort. Always make a plan to pay off high interest credit card debt as soon as you can.
Remember, a healthy emergency savings account is the first step in any financial plan. Make sure your account can cover likely expenses in an emergency, and put it out of reach. If you don't have a huge stash, remember that you may have other sources of cash to protect you if the worst happens.