Nobody can predict when an emergency will happen. An emergency could be anything from your air conditioning unit at your house going out to breaking your foot and needing surgery. No matter what the emergency is, it will cost you money to fix. An emergency fund is an amount of money set aside to pay for any emergency that happens in life. If you do not have money set aside in an easily accessible account, emergencies can cause stress, debt, and sometimes even foreclosure or eviction. Do not fall prey to the thought that you can cash flow emergencies. What happens if you lose your job and your car breaks down at the same time?
How much? When determining the size of your emergency fund, you want to think of the worst emergency that could possibly happen to you: losing your job. Therefore, a general rule of thumb for an emergency fund is to save between three to six months of expenses. To figure out your monthly expenses, add up all of your unavoidable monthly payments like mortgage/rent, cell phone bill, cable bill, water/electricity bill, groceries, insurances, etc. Saving this amount will allow you to continue to live stress free and not worry about money for three to six months while searching for a new job. If you do not have an emergency fund and lose your job, you will have to focus on figuring out how to pay bills rather than searching for a new job and your unemployment can be prolonged.
When? Right away. Besides getting out of debt, establishing an emergency fund is the most important thing to do to become financially stable. Unfortunately, Murphy’s Law, “what can go wrong, will go wrong”, seems to always be true when the emergency fund is unfunded. Before buying a house, a car, a tv, anything, make sure to fully fund your emergency fund. As soon as you have to use funds from your emergency fund to cover an event, make sure to fully fund it again as soon as you possibly can. Halt all other “extra” expenses like eating out until the emergency fund is fully funded again.
For what? As the name hints, your emergency fund is for emergencies ONLY. This does not mean those new shoes that you just had to have, that new TV because your old one was too small, or that back massage that will help you clear your mind. You must teach yourself to have enough self-discipline to not use this money for every day purchases as well, no matter how tough times get. Emergencies are situations or events that affect your ability to live or make money. Typical examples are crucial parts of your house/apartment breaking, medical problems, car troubles, and loss of a job. If you start using the funds for non-emergencies, then there will not be any funds available when you actually need them one day.
Where? You want to keep your emergency fund somewhere that is easily accessible. Most emergency situations require immediate funds. What is the point in having a fully funded emergency fund if you cannot access it right away. This means do not invest it in a CD, bond, or stocks. The funds need to be liquid, which means cash. The best option is to put it in a high yield money market account with a debit card and check writing capabilities. These accounts will normally have around a 1% APR. Your next option would be a normal savings or checking account. And a last resort would be cash in a safe. The benefit of the accounts listed over cash in a safe is that they are FDIC insured. Do not worry about “losing money” due to inflation. The purpose of this money is to help pay for emergencies, not grow wealth. That is what a brokerage account is for.