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Reasons to Set Up an Emergency Fund

Written by Preet Banerjee

Friday, June 22nd, 2018

If you had a truly dire financial emergency, you might reach out to a family member or close friend who could put you up on their couch or provide you money.

But you certainly wouldn't call them in a panic if you couldn't afford to enroll in a summer beach volleyball league, or if your auto insurance premium jumped up 10%.

Financial Emergencies vs. Unplanned Expenses

There's a difference between a financial emergency and the unplanned expenses that are part of everyday life. And simply having a buffer for non-monthly expenses that pop up from time to time is not the same thing as having an emergency fund.

If you have a car, you probably know that you don't normally pay $100 or $200 per month in maintenance costs like clockwork, but instead get dinged with $1,000+ repair bills from time to time. Maintenance costs aren't emergencies —they're just maintenance costs. They need to be part of the budgeting process.

If your friends decide to take an impromptu road trip to wine country for the weekend, that's supposed to come out of your budget for entertainment and leisure, not your emergency fund.

An emergency is something that could derail your finances, or materially change your financial trajectory in life. They tend to be out of your control, too. Losing your job is a prime example. Becoming disabled through injury or illness is another. A series of irregular, large expenses piling up at the same time can also qualify.

Why Should Emergency Funds Be So Big?

When an emergency strikes, no one asks that question. But when you're reading all the articles that suggest you should set aside enough money to cover three-to-six months' of living expenses (some suggest instead of living expenses, it should be your income before taxes), it can seem daunting.

But to give you an understanding as to why you need a plan for relatively large amounts, think about simulating an emergency with your finances. What would you do, and how long would you be able to maintain your lifestyle without triggering a nuclear option (like selling your house or moving back in with your parents)?

If you walked into work tomorrow and got laid off, how many months do you think it would realistically take to find a new job?

If you become disabled, hopefully you either have disability insurance provided through your employer or you have your own private policy, but benefits tend to kick in after three months. An emergency fund can bridge the gap during those three months.

The answer to just how big your emergency fund should be will depend on a few factors. Perhaps you work in a particularly cyclical industry. The bad times might last longer than three months, for example. If you're the sole income earner in your household, that's another consideration. While rules of thumb offer a good starting point, as they say, "personal finance" is very personal.

Save First, Ask Questions Later

Saving up a lot of money takes time. The best thing you can do is start. Start a regular contribution, even a small amount, into a bank account separate from your daily banking account, but still easily accessible on short notice.

I've seen people get caught up in comparing interest rates or calculating the opportunity costs of money sitting in a GIC or bank account versus being invested in the markets, and while these are good things to think about once you have money set aside, they're horrible things to focus on if they get in the way of actually accumulating funds to rely on in an emergency in the first place.

When I was younger, it was certainly feasible that an emergency would necessitate the "nuclear option" of moving back in with my parents. You need time to earn money and convert that into a firm financial foundation. But after some time, you pass that period of financial fragility by having your own assets to fall back on in case of emergency.

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