This is the second part of my series on Personal Finance Basics. The first part on Budgeting is here.
Why do I need an Emergency Fund?
In short, shit happens and it’s better to proactive than reactive when it happens. The goal is to reduce the amount of disruption to your life by managing emergencies with advance planning.
How much do I need?
I can’t tell you how much because everyone’s situation is different. However, I can tell you how to go about figuring out how much you need. Think about the major circumstances that could disrupt your current lifestyle. Some questions to ask yourself include:
- How stable is your job?
- Are you dependent on another’s income to maintain your current lifestyle? How stable is your live-in significant other’s job?
- How long do you or your live-in significant other think it would take to get another comparable job in the event of a job loss?
- Are you eligible for a severance package and/or government-provided unemployment benefits? If yes, how much is it and how long will it last?
- How would a job loss effect your health insurance? How much would COBRA cost to support your family?
- What are your home, auto, and health insurance deductibles?
- Do others depend on you for your income? What and how much are their critical expenses?
- How much money will you need to pay for your home and other critical expenses if you have reduced or no income?
Your biggest concern should be how much will you need to pay for the roof over your head and the critical utilities associated, so at the very least you need to have a cash emergency fund that covers that expense for however long you anticipate it would take you find a new comparable job. Why cash? You need a cash emergency fund specifically for your housing expense because in most cases you cannot use a credit card to pay those, and doing a cash advance on a credit card or at a payday lender is not a wise option as they can send you spiraling into debt quickly.
Your next concern should be your insurance deductibles. You need to have enough to cover home, auto, and health insurance deductibles. Hopefully you know these numbers, but if you don’t call your insurance agent(s) or look at your declarations pages. You will need to contact the HR department at your job if you do not know your health insurance deductible. This may seem like overkill, but Murphy’s Law is a bitch! You want to be adequately prepared in the event you loose your job, home, and car on the same day.
After the biggies I’ve listed above your next concern is whatever you determined to be your next priority expense after home and utilities when you created your prioritized budget.
Once you have tallied your critical expenses multiple the number by the number of months you anticipated it would take to find a comparable job. WARNING!! This number will likely be very large and that is fine. Remember you won’t be funding this emergency fund in a single month; you will likely be funding this emergency fund over a long period of time.
What should I NOT use as an emergency fund?
- a HELOC
- any of your retirement accounts (401k, 403b, TSP, IRA, Roth IRA)
Using a HELOC as an emergency fund is basically leveraging your house for a loan that you must pay back at a variable interest rate. First of all there is no guarantee you will qualify. Second of all if you do qualify the bank can freeze or revoke your HELOC at any time. Third of all you are incurring debt when you don’t have enough money coming in. Do you really think this is a good idea?
Now let’s assume you do qualify. What happens if you can’t pay back the loan? The answer is YOU LOSE YOUR HOUSE! If you don’t have an emergency fund you are far better off using a credit card. Yeah the interest rate if significantly higher than HELOC, but if you can’t pay back the credit card debt you can always declare bankruptcy and still keep your home.
Your retirement account:
Regardless of the type of retirement account, you will always pay at least a 10% penalty and you will owe taxes on the amount you withdraw. While there are exceptions, I guarantee your emergency isn’t one of them. I’ll talk about retirement account later in this series.
The bottom line for both of these suggestions is DON’T DO IT!
How should I fund my emergency fund?
First you need to determine how much you are able to contribute to your emergency fund every month, so take a look at your expenses. This should be easy if you are using the budget template I recommended. Hopefully you have excess money. If not you need to reduce your least important expense and reallocate that money to your emergency fund. You need to contribute some amount to your emergency fund every single month. It doesn’t matter if the amount is $5 or $1000. Treat this amount as a non-negotiable fixed expense.
If you have direct deposit, the easiest way to fund your emergency fund is to contact your HR department and setup an automatic deduction from your pay check to a separate savings account. It’s a case of out of sight out of mind. If it’s gone before it reaches your main spending account you won’t miss it.
If you don’t have direct deposit you will have to be disciplined enough to transfer the money yourself. This is easy if you use online banking, since you can setup recurring automatic withdraws. However if you don’t do online banking then you’ll have to visit the bank and/or do wire transfers depending on where you store your emergency fund.
Where should I store my emergency fund?
The best place to store the majority of your emergency fund is at an online bank in a high yield savings account. Online banks do not have as many overhead expenses as the brick and mortar banks, so they can offer you much higher interest rates, no minimum balances, and no maintenance fees. Online bank interest rates are currently ranging from 2.75% to 3.25% or so. Brick and mortar banks usually offer less than 1% for savings accounts and charge you maintenance fees unless you have other accounts with the bank, adhere to certain terms like x number of online bill payments per month or less than x number withdraws, and/or maintain high minimum balances.
My favorite online banks are:
- FNBO Direct – backed by First National Bank of Omaha
- ING Direct – backed by ING
- HSBC Direct – backed by HSBC Bank
I have accounts at each of these and have never run into any problems funding or accessing my accounts. All of these online banks are FDIC insured, have excellent user-friendly interfaces and customer service.
FNBO Direct is my favorite because every time I contact customer service I speak to someone in Omaha! I like that they don’t outsource their customer service out of state or out of the country. FNBO Direct also has the highest interest rate (3.25%) of the three right now.
ING is a close second though. I only left them because their interest rate was not as competitive than their competitors at the time. ING also offers referral bonuses. Your referee gets $25 with a $250 initial deposit, and you get $10. Here’s one referral. If that referral is inactive, send me an email at the address listed here and I’ll send you one.
HSBC is my least favorite only because its login procedure is a bit tedious.
Now the major pro with online banks is the higher interest rate. The major con is it will take 2-3 business days to get your money. Now chances are there isn’t an emergency that will require a lot of cash in less than two days. However, if it will ease your mind keep a small part of your emergency fund at your brick and mortar bank once you have established half of your emergency fund. I don’t want you to be tempted to raid your emergency account
When should I start my emergency fund?
ASAP!!! You should either fund your emergency fund before you accelerate paying off any debt or do both concurrently. Personally I would fund the emergency fund first. I know others look at the math and say since the interest on your debt is generally higher than the interest on your savings account paying off your debt is better, and this is true mathematically. However if you have an emergency without an emergency fund you will accrue more debt, which can be very discouraging when you’re trying to get out of debt in the first place.
Ok, let’s recap:
- You need an emergency fund.
- Only you can determine how much of an emergency fund you need.
- Your emergency fund contribution is a non-negotiable fixed expense, so put it on autopilot.
- Store your emergency fund in a high yield savings account at an online bank to maximize your interest earnings.
- Start right now!
FYI, if anyone actually takes my advice I would love to hear about your progress!