Not too long ago, a poll in Parenting Magazine said that 49% of Americans could cover less than one month’s expenses if they lost their income. That means half of this culture has virtually no buffer between them and life.

Here comes Murphy (Murphy’s Law: “Anything that can go wrong will go wrong!”).

 

It will rain; you need an umbrella. Money magazine says that 78% of us will have a major unexpected event within the next ten years. When the big stuff happens, like the job layoff or the blown car engine, you can’t depend on credit cards. If you use debt to cover emergencies, you’ve backtracked again. A well-designed Total Money Makeover will walk you out of debt forever. A strong foundation in your financial house includes the big savings account, which will be used just for emergencies. Putting together a fully-funded emergency fund is step 3 of your Total Money Makeover. Before you reach this point steps 1 and 2 should be completed. You should have $1,000 in the bank and be debt free, except for the house.

A fully-funded emergency fund covers three to six months of expenses. What would it take for you to live three to six months if you lost your income? Financial Planners and Financial Counselors, like me, have used this rule of thumb for years and it has served participants well. You start the emergency fun with $1,000, but a fully-funded emergency fund will usually range from $5,000 to $25,000. The typical family that can make it on $3,000 per month might have a $10,000 emergency fund as a minimum. What would it feel like to have no payments but the house and $10,000 in savings for when it rains?

So, what is an emergency anyway? An emergency is something you had no way of knowing was coming, something that has a major impact on you and your family if you don’t cover it. Emergencies include paying the deductible on medical, homeowner’s, or car insurance after an accident, a job loss or cutback, or a blown transmission or engine on a car that you need to function.  Something on sale that you “need” is not an emergency. Fixing the boat, unless you live on it, is not an emergency. “I want to buy a car or a leather couch or go to Cancun” is not an emergency. Prom dresses and college tuition are not emergencies.

Beware not to rationalize the use of your emergency fund for something that you should save for and purchase. On the other hand, don’t make payments on medical bills after an accident while your emergency fund sits there fully loaded. If you’ve gone to the trouble of creating an emergency fund, make sure you are crystal clear on what is and is not an emergency.

Before you use your emergency fund, back up from the situation and calm down. Sharon and I would never use the emergency fund without first discussing it and being in agreement. We also would never use the emergency fund without sleeping on the decision and praying about it. Our agreement, our prayer, and our cooling-off period all help us determine if this decision is a rationalization, a reaction, or a real emergency.

Keep your emergency fund in something that is liquid. Liquid is a money term that means easy to get to with no penalties. I use growth-stock mutual funds for long-term investing, but I would never put my emergency fund there. Mutual funds are good long-term investments, but because of market fluctuations, you are likely to have an emergency when the market is down—another invitation to Murphy.

I suggest a money market account with no penalties and full check writing privileges for your emergency fund. Remember, this account is not for building wealth. It’s more like an insurance policy against rainy days. The mission statement for the emergency fund is to protect you against storms, give you peace of mind, and keep the next big problem from becoming debt!

— Dave Ramsey