What Is an Emergency Fund?

There’s always a rainy day just around the corner, and this goes for your finances as well as the weather. A financial rainy day is an unexpected expense that you didn’t budget for, because there was no way to anticipate it. It could be a leaky roof, a flat tire, or a trip to an urgent care clinic to get stitches. And the way you meet those surprise bills is with your emergency fund.
For the last three years, we’ve all been living through the COVID-19 pandemic, and you likely remember all the layoffs at the start of it, back in spring 2020. People who lost jobs and didn’t have cash savings were in a much worse position than those who did. While this was a particularly acute situation, there have been others like it throughout history. Perhaps your grandparents or great-grandparents kept a “rainy day fund,” consisting of cash or precious metals. Today, it’s far more likely that your emergency fund is in a high-yield savings account, but the purpose of the money is the same.

Let’s take a look at the finer points of emergency funds, whether you should pay off debt firsthow much you should save, and if it’s a good idea to also keep some cash on hand.

What kind of expenses are emergencies?

Ideally, your emergency fund exists purely to pay for surprise expenses you can’t cover with your normal paychecks. This could look like the examples above, or it could also be paying your homeowners insurance or auto insurance deductible so you can have a home or car repair made. It could also be an extreme situation like losing your job and needing to cover your bills for a few months until you can get a new one. A big sale at your favorite store is not an emergency. Neither are concert tickets or a vacation. The purpose of this money is to pay a bill or keep you afloat for a time without needing to go into debt.

Pay Off Debt vs. Save an Emergency Fund

Speaking of debt, if you have high interest debt (such as credit card debt), you’ll need to balance saving for emergencies alongside paying it off. Remember, credit card interest rates can be 20% or higher, so it’s best to get out from under it as soon as possible.

Finance guru Dave Ramsey recommends saving a $1,000 mini emergency fund before tackling debt payoff, and there is some wisdom here. If you’re actively working towards debt payoff, it can be disappointing to have to put an emergency bill on a credit card. You might also consider saving up one month’s worth of expenses before tackling debt, to give yourself some protection. Don’t fall into the trap of focusing on just saving for emergencies while not paying down your debt.

How much should you have in your emergency fund?

Traditional wisdom is to have three to six months’ worth of expenses saved up. This includes your essential monthly bills, like housing, utilities, and insurance. If you’re following the Money Management System for budgeting (where you characterize your musts, shoulds, coulds, and won’ts, for spending), you’ll want your emergency fund to cover your monthly musts at the very least – your essential bills. You may also decide to cover some shoulds too.

There’s a big difference between three months and six months of expenses, so how do you decide how much to save? Look at your financial circumstances. The Childfree community generally doesn’t have to worry about kid-related emergency expenses, but if you are responsible for caring for family members, or you have a lot of pets, figure in those costs. And look at your employment circumstances. If you have a fairly stable job, three months might be enough for you. But if you’re self-employed or have variable income, aim for six months.

Where should you keep your emergency fund?

Three to six months’ worth of expenses might be a lot of money, depending on how much your monthly bills are, and you might wonder if you should invest that money, rather than letting it sit in a savings account. No, it’s not a good idea to invest your emergency fund. The stock market fluctuates, and there’s no way to guarantee you won’t lose money, especially in the short term. If you have $18,000 in your emergency fund to cover six months of bills and you invest it, and the market drops 20%, and you have an emergency, you won’t be able to afford six months of bills if you have to take your money out.

Instead of investing your emergency fund, choose a good high-yield savings account. Some accounts offered by online banks are paying upwards of 4% APY right now, so you will earn some interest on your cash. And if you have to tap the account to cover an emergency bill, aim to refill it as soon as possible so you’re protected for the future.

Should you also keep cash on hand?

If you’ve got your emergency fund in a high-yield savings account and it’s fully funded, you’re all set, right? Maybe not. It’s a good idea to keep some money in cash, too. If you’re caught in a weather emergency and without power, for example, you’ll still need to buy food and potentially gas for an emergency generator. You might need to rely on that cash if credit/debit processing isn’t working. Similarly, you may want to keep some cash in your wallet; I recommend $100, just in case of emergency.

No matter what life throws at your finances, your emergency fund can go a long way towards helping you handle it. Prioritize paying off high-interest debt and build your emergency fund, so you’ll be ready.