You understand the importance of an emergency fund and have done a great job in setting one up.
Financial security has been achieved.
It’s important to make sure you don’t spend your emergency fund on the wrong thing, reserving it for true emergencies.
Learn how to identify the correct situation when it makes sense to use an emergency fund (and when it doesn’t).
How Not to Use an Emergency Fund
Here are a few examples of things you shouldn’t use your emergency fund on.
Spending money can be fun. Fancy meals out, a new outfit, or a shiny electronic gadget can all be very tempting.
This temptation can get even worse if you have friends who invite you out for a meal or who are constantly upgrading their own gadgets, making you feel like you’re getting left out.
If you have a lot of money in your emergency fund, it might not seem like a big deal to spend a bit of it on something fun. This is a dangerous precedent to set. One small splurge can quickly become two small splurges, and then three. Soon enough, you’ll find yourself with no emergency fund at all. If a real emergency comes around, you won’t have any way to cover the expense.
This is why setting a budget based on your income is so important. By budgeting for spending on fun, you can stay within your means while having guilt-free money that you can use on whatever you’d like.
Fear of Missing Out on Sales, Deals, or Discounts
Companies, whether they be clothing stores or car dealerships, constantly advertise deals, sales, and discounts on their products. No matter how great a deal seems, it’s not worth spending your emergency fund because you’re afraid of missing out. More likely than not, the product you want will go on sale soon enough.
If something is on sale for an event like Black Friday, you should think about that before the day of the sale comes. Set aside money specifically for use on the day of the sale, that way you have extra cash to go shopping and take advantage of the discounts.
Paying for Home Improvement That Can Wait
Owning a home is like having a constant DIY project to work on. If you have a lot of cash in the bank, it can be tempting to start a new home improvement project, whether it be making an addition, repainting a room, or buying new appliances.
You shouldn’t use your emergency fund for this purpose for a few reasons.
Most obviously, because home improvements, short of repairing catastrophic issues, isn’t an emergency. Emergency funds are for emergencies, not unneeded spending.
Second, even the best-laid home improvement plans can go awry and a small project can quickly become a big one. You don’t want to commit a small part of your emergency fund to a project only to find you need to spend all of your savings to finish it.
A New Car if Your Current One is Fine
Having a car is essential for most Americans. Public transit in all but the largest cities leaves much to be desired and even then it can be inconsistent. You need some way to get to and from work and to be able to travel around.
Cars can also be a fun hobby for many people. It’s not unusual to dream of owning a luxury car or to want to upgrade from your current model. Still, if your current car runs fine, you shouldn’t spend your emergency fund on a new one. Not only will you lack savings to handle true emergencies, you’ll also lock yourself into a new, and possibly expensive, car payment.
When it Makes Sense
Here are some reasons you might use your emergency fund.
You Need a Livable Shelter
One of your first priorities should be having a place to live. If you find yourself without livable shelter for whatever reason, tapping your emergency fund to find somewhere to stay is a good idea. If your roof starts leaking or your utilities are going to be shut off, you should use your emergency fund to rectify the situation.
Utilities like cable, internet, or subscriptions like Netflix are not essential, so you shouldn’t use your emergency fund to cover those bills. Focus on what you truly need: a good roof, electricity, and heat.
You Need to Get to Work
If you don’t have a way to get make money, you won’t have a way to pay your bills or rebuild your emergency fund after you deplete it. If your car breaks down, using your emergency fund to pay for the repair makes perfect sense. If you lose your job because you didn’t fix the car, your emergency fund wouldn’t last long, so using it to ensure you keep your job is a good idea.
You Need to Find a Job
Relatedly, if you need to spend money so you can find a job, do so. This can mean covering your living expenses, which you should reduce to the bare minimum, or it can mean buying an adequate outfit to interview in.
It might also mean purchasing transportation to get to and from interviews or to get the necessary education to find a job. Don’t spend too much on things that aren’t truly necessary. A coding boot camp, for example, isn’t guaranteed to get you a job. But, for example, if you don’t own any formal clothes, buying a shirt and tie to use for interviews would be a good investment.
You Need to Stay Healthy
The most important thing you have is your health. If you’re unhealthy, your quality of life will decrease dramatically. Of course, your ability to earn money to sustain your lifestyle will also decrease if you are unhealthy.
If you get sick, have an accident, or some other health issue comes up, spend your emergency fund on the required treatment. Visit the doctor, get the recommended tests, and do whatever you can to get healthy again. You can worry about rebuilding your emergency fund when you’re better.
The Size of Your Emergency Fund
Once you’ve decided to build an emergency fund, you have to decide how large an emergency fund you need.
A good rule of thumb is to start by saving up $1,000. This is a relatively small amount, but it is enough to handle most minor issues that pop up, like a car repair or unexpected bill.
Once you’ve built your initial emergency fund, focus on paying off high-interest debt. Depending on your risk tolerance and willingness to pay interest, paying off any debt that charges more than 4-6% interest should be your target. You can continue paying the minimum on your lower interest debt.
After you’ve eliminated your high-interest debt, go back to building an emergency fund. Depending on a variety of factors: how many dependents you have, your level of job security, and how hard it would be to find a new job, aim to have 3-6 months’ expenses in your emergency fund. So, if you spend $2,000 a month, aim to have $6,000-$12,000 on hand at all times. This amount will help you weather the storm if you wind up losing your job and have to find a new one.
Where to Keep Your Emergency Fund
There are a few options to choose from when deciding where to keep your emergency fund.
Online Savings Account
The simplest option is to keep your money in an online savings accounts. These accounts rarely charge fees and pay great interest rates. This means that your money will grow over time and helps fight against the effects of inflation.
Online savings accounts sometimes make it difficult to make withdrawals, but if you choose the right bank, you can make electronic transfers without much trouble.
Money Market Account
Money market accounts combine the benefits of savings accounts and checking accounts. They pay a good rate of interest and give you the ability to write checks against the account. That makes it easy to access the money when you need it. As a bonus, many banks offer debit cards with their money market accounts.
The greatest downside of money market accounts is that they tend to have high minimum deposit requirements.
Money Market Funds
Not to be confused with money market accounts, money market funds are offered by investment brokerages as a way to store extra cash. These accounts are not insured by the FDIC, but they can pay a great interest rate. Some brokerages offer rates higher than online savings accounts.
Moving money out of a money market fund is easy. Some brokerages even let you write checks against the account.
Building an emergency fund is an important step in everyone’s financial life. Once you’ve taken that step, make sure that you don’t spend the money frivolously, saving it for true emergencies.