An emergency fund isn’t a luxury—it’s a necessity. This type of fund exists to protect you from circumstances that are beyond your ability to foresee. If you don’t have an emergency fund when a situation calls for it, you may have to start living off of credit cards, or have to pull money out of your retirement fund. Both of these options can be financially devastating.
Credit Card Debt
Credit cards are one of the most expensive ways that you can borrow money. Short of payday and car title loans, you’re not going to find a way to borrow money at higher interest rates. Moreover, credit card debt could delay your retirement. It’s generally a bad idea to go into retirement before you retire all of your debt. If you do that, you’re going to have to earmark a portion of your retirement savings for debt repayment. And that’s going to seriously cramp your retirement lifestyle.
Early Withdrawals From Your Retirement Account
Dipping into your retirement account to pay for an emergency can be even worse. Here’s why:
1. It is possible you won’t be able to pay yourself back.
2. You’ll pay heavy taxes and penalties and possibly end up with a smaller balance at the end of the day.
3. The money that you take out of a retirement account can’t accrue value in your pocket like it can in your IRA or other tax-preferred investment instrument.
In sum, taking an early withdrawal from your retirement account can mean robbing yourself of principal and minimizing your own returns.
Calculating How Much To Put Into Your Emergency Fund
So, how much do you need in your emergency fund? Three months of living expenses is an absolute minimum, but it’s better to shoot for six months. Note that “living expenses” means all of your living expenses—not just rent. Calculate all of your standard living expenses, from groceries to gifts to the occasional cup of coffee at your favorite cafe. One way to come up with a budget is to pay for everything with your credit or debit card for a month, then review the statements to see precisely how much money you “need” as opposed to how much you’re spending on discretionary expenses. Take one month’s expenses, multiply them by three to six, add in any expenses that you pay regularly but not every month (like a bi-annual insurance premium bill or quarterly tax payment) and…voila. That’s what you need in your emergency fund.
Once you have that number, you need to be set about saving that amount. If it comes down to it, this might mean contributing less to your retirement fund for a short period of time. That’s fine, though, because your emergency fund protects your retirement fund. Once you have the six month emergency fund, don’t touch it unless (you guessed it) there’s an emergency.
How To Use Your Emergency Fund
Deciding what constitutes an emergency is not entirely an objective science. In general, an “emergency” is anything unexpected that impacts your ability to live or work. This means, for instance, that you can use the fund to cover an unexpected medical bill, or pay rent when you’re unemployed. However, when you take money out of an emergency fund, it’s important that you pay yourself back as soon as possible.
Also, be sure to resist the urge to rely on your emergency fund for predictable but infrequent expenses, like replacing your car’s tires after a certain number of miles. To help avoid the “surprise” of infrequent bills, simply factor them into your monthly budget. Using car expenses as an example: look over your records and total up what you spend on your car each year (beyond gas, be sure to consider insurance, maintenance, and repairs), and divide that total by 12. Save at least that much towards your “car fund” each month, so you have a buffer to pull from when the big bills hit. And voila! Big “surprise” bills become a bit less painful.
You’ll probably find that having an emergency fund makes things like paying down whatever credit card debt you currently have a lot easier because you’ll no longer be using credit cards to plug gaps in your income. Also, since you won’t be borrowing from your retirement account, you won’t have to worry about sacrificing your future lifestyle to cover your present needs. Emergencies are never fun, but by removing some or all of the financial stress from the situation, you’ll be better equipped to focus on other things that matter.
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