Job loss. Unexpected illness or injury. Theft.
When my family first decided to open an emergency fund, it was to protect ourselves against these major unexpected financial expenses. While that continues to be a reason we maintain an emergency fund, it is the smaller unexpected expenses that make this account essential to us.
As I outlined in a separate article, we learned to better understand our monthly expenses and know approximately how much we spend in a typical month. This is important to us because part of our paycheck goes to monthly expenses and the rest is automatically invested or put toward our mortgage. In order to have fairly stable monthly expenses, we need to account separately for the inevitable small expenses that arise at unexpected times.
Consider the various unexpected expenses we incurred in the last 12 months, mostly from my wife’s nine year old Jeep Grand Cherokee:
- $115.60 new car battery for my car in July 2016
- $236.46 new car battery for wife’s car in October 2016
- $441.93 new ignition switch starter for wife’s car in November 2016
- $309.26 two new tires for wife’s car in January 2017
- $129.33 replacement tire holder for wife’s car in February 2017
- Grand total: $1,232.58 last 12 months
While these expenses are not job loss or illness-level expenses, they are large enough to alter the monthly budget our family has in place. That may mean the next trip to the auto repair shop puts our monthly expenses over the amount we have in our checking account.
Luckily we are no longer strapped with student loan debt and we have two paid-off cars. Instead of putting extra month toward debt, we are able to put extra money toward retirement, kids’ educations and taxable investments. So theoretically we could dip into the taxable investment account without penalty to fund unexpected expenses.
But these investment accounts are set up to save for future goals. The intention is not to use them for costs today, but rather to let them compound over many years in the stock market. If we leaned on these accounts for small emergencies, it would degrade our ability to accurately save for the future goals we set for our family.
Enter — The Emergency Fund
The first line of defense when unexpected expenses arise is our emergency fund. We keep our emergency fund in a high interest savings account at Ally Bank (LOL at “high interest,” but 1% is about as high as you can get these days). We are normally fairly aggressive with our money, wanting to place it in the market to maximize earning potential, especially while we are young. But we treat an emergency fund as just that — an emergency fund. If the need arises to access the money in this account, it doesn’t matter if the market has recently crashed…all of our money will be there.
Our emergency fund is more than just a defense against major unexpected financial expenses. We use it when small unexpected financial expenses, like car repairs, arise. Since these small unexpected expenses are actually quite expected over time, we continually replenish the emergency fund with automatic deposits of $100 each month since our unexpected annual expenses have averaged about $1,200 per year recently.
Essentially, we are self-insuring our monthly budget by keeping a separate account for expenses outside our regular budget. This accomplishes two things for us:
- Helps us maintain a fairly steady spending budget month-to-month since we do not include unexpected expenses.
- Significant peace of mind. When the call from the auto repair shop comes that we need a new ignition switch (huh?) for $450, we do not worry about where the money will come or suddenly need to substantially cut other expenses that month.
How Much We Keep In An Emergency Fund
Many financial experts say 3-6 months of living expenses is appropriate for an emergency fund and can help offset short-term job loss or unexpected expenses. My wife and I have maintained about 5-6 months in our emergency fund for the last four years.
We keep our emergency fund at the upper end of the recommended range for three primary reasons:
- We use it to offset small unexpected expenses since we only maintain enough cash in our checking account to pay that month’s regular expenses. The rest is invested. So the savings account that holds our emergency fund is the first and only line of defense before we would need to sell some investments.
- We own a 92 year old house. Yes, we have insurance. But small fixes are frequently necessary. The house — knock on wood — was free from any unexpected expenses this past year. But having lived here since 2012, I know this is not a typical year.
- We have young children. They break stuff. They draw on stuff. Everyday is an adventure. Everyday is unexpected.
Everyone’s situation is different. How do you approach saving for emergencies? Do you set money aside, or do you rely on credit cards as your only backup plan?