What is an Emergency Fund?
According to the Financial Dictionary, an emergency fund is a reserve of cash kept available to meet the costs of any unexpected financial emergencies. It is designed to provide financial back-up for unexpected expenses or for a period when you aren't working and need income.
An emergency fund should be used only for true emergency expenses, such as an important appliance like a fridge or stove dying, an unexpected car repair, an unexpected medical expense, or a layoff. If you have a planned big expense such as braces or a new vehicle, you should save for it rather than tapping your emergency fund. Plus, if you have to use some money from your fund, your goal should be to replace it as soon as possible.
How Much Should You Keep in Your Emergency Fund?
Most experts agree that you should save 3-6 months of living expenses. The exact number depends on your family situation…whether you have only one income supporting a family, you're single, you have dual incomes, etc.
However, it can seem daunting to save that much money. The best way to build your emergency fund is by setting small goals. For example, Dave Ramsey suggests you should create a $1,000 emergency fund before you start doing anything else. That way you at least have a small buffer against expenses while you tackle the next step – paying down debt.
What do you do in a time of recession? Should you pay down debt or create a larger emergency fund? It's really up to you, but if you really think that you will be facing a layoff soon, I would try to beef up the emergency fund as much as you can. Then, if you are not laid off, you can take the extra money and apply it towards your debt in one lump sum.
Where Should you Keep your Emergency Fund?
You want to make sure that you keep your emergency fund very liquid (meaning somewhere where you can access the money quickly without a large drop in its value). So, you do not want to put your emergency fund in real estate or even in the stock market really. We keep our fund in money markets, but other people use short-term CDs. You do want to make sure that your money is earning as good a rate as possible for those types of accounts.
Do you have an emergency fund? How did you build it up? Did you use small goals? Where do you keep your money?