An emergency fund is a critical tool in the journey of staying debt-free. You won’t need a credit card to pay for emergency expenses.
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Step 7, paying off debt, is probably going to take at least a year. For many people, it will take even longer. Keeping that in mind, know that your hard work isn’t over even when you have paid off your consumer debt. You need an emergency fund to stay out of debt.
You should have established a mini emergency fund before paying off debt and maintained it during the debt payoff journey. Once all your debt is gone, other than the mortgage, the next step is saving up at least 6 months of expenses to fully fund your emergency fund.
If you’re still paying off debt…
This article is for informational purposes only. Don’t worry about the next step until you’ve completed the one you’re on.
When your debt is gone, it’s OK to take a (short) break. Enjoy a slower pace, not pinching every penny, for a week or even a month. Celebrate with a fancy dinner, a trip, or a long-delayed frivolous purchase. Then get back to work!
It will be easier to step back into serious-finance mode if you don’t take a long break. Stay in the habit of budgeting and watching your spending. If paying off your debt takes years, it will probably actually be hard to spend frivolously by the end of the journey. That’s a good thing since it’ll help you accumulate money for your emergency fund.
What is an emergency fund for?
Your mini emergency fund is for unexpected expenses while you’re getting out of debt. It’s a relatively small amount, only a couple thousand dollars. Once your debt is paid off, you can roll the mini emergency fund into your big emergency fund.
A fully-funded emergency fund is intended to protect you in the event of a months-long job loss or other big emergencies. Obviously, it needs to be a much larger amount.
You decide what your emergency fund should cover, but you don’t want to drain it unless it’s a true emergency. Your emergency could be used for:
- Living expenses during a layoff
- Repairs after damage to your home
- Medical expenses from an accident or injury
- Veterinary testing, surgery, or hospitalization
- Vehicle repairs.
It’s important to discuss the rules of your emergency fund with your partner if you have one. You should agree on what the funds are for and how you decide what an emergency really is. There’s no right answer, but you need to be on the same page for harmony.
What is an emergency fund NOT for?
I would not recommend using your emergency fund for:
- Home remodel
- Vehicle replacement
- Routine medical expenses
- Annual vet exams
- Vehicle maintenance
- Semi-annual auto insurance
- Vehicle licensing fees
- Homeowners insurance, if not paid through your mortgage escrow
Routine or recurring expenses should be budgeted and saved for. Create sinking funds for things like 6 months of auto insurance, annual vet visits, and vehicle maintenance. Calculate how much to save each month to be able to pay the full amount when it’s due.
The Bill-Balancing Bootcamp walks you through how exactly to implement this strategy. It’s really a simple method of getting ahead financially, but there is some math involved. For only $27, you can enroll in the course too!
If you use your emergency fund for recurring expenses, you’re going to be withdrawing and depositing money into that account constantly. It’ll be simplest to budget for recurring expenses separately and leave the emergency fund alone until it’s truly needed.
You also want to make sure the money is available when you really need it. Spending a bunch on a kitchen remodel is going to be a terrible decision if you lose your job halfway through.
How to start an emergency fund
The easiest way to start an emergency fund is to schedule automatic transfers from your regular checking account to your EF savings account. Start off by saving the amount you were spending each month on debt payments.
You’re already used to living without that amount in your spending budget, so it’s not going to change your daily life to save it now.
When you get extra money, like a tax refund or bonus, put it toward your emergency fund. That’s my plan for when we’re done paying off debt & we start working on our emergency fund.
We are balancing my intensity with my husband’s free spirit through a compromise. Sometimes when we receive out-of-the-normal lump sums, we agree that we will pay off debt with most of it. We then put some of it in our “fun money” checking accounts (we each have our own account for our bi-weekly fun money deposits). Both of us have bigger purchases we’d like to make that aren’t really in the family budget, so we’re both saving fun money for those items.
How much should your emergency fund be?
Dave Ramsey recommends saving 3-6 months’ worth of expenses, but I urge you to save at least 6 months. If you have a child with special needs, work toward 1 years’ worth of expenses, because you know that kid is going to be expensive. Trust me, they find new and interesting ways to cost money.
You can decide what exactly 6 months of expenses means to you. It could mean ALL of your expenses, including unnecessary things like eating out and all three of your streaming services. It could mean the absolute essentials or something in between. Essentials vs every expense will probably be pretty different numbers.
Since you’ve been budgeting and tracking your expenses for months or years by this point, it should be pretty easy to add up your monthly expenses, then multiply that number by 6. That’s your goal.
Use the Emergency Fund Worksheet to add up everything AND track your savings progress.
Where do you keep the money?
Where to keep your emergency fund has a boring answer: in a savings account.
You want the funds to be accessible without penalties in case of an urgent emergency. This is why a retirement account is not an emergency fund. Withdrawing funds from most retirement accounts before you’re old enough will incur penalties with the IRS. You’ll also have to pay income taxes on withdrawals from a pre-tax account, like a 401(k).
Also, you don’t want to lose your emergency fund savings in the stock market. That’s why you shouldn’t put your money in an investment account either. You could see huge gains, but when the market drops, so will your emergency fund balance… and that’s probably when you’re going to need that money the most.
Finally, you don’t want your money to be too accessible if you’re prone to overspend. If you’re worried about being tempted to spend the fund when you shouldn’t, keep it in a savings account in a bank that you don’t use otherwise. The money will still be accessible if you need it, but that big amount isn’t staring you in the face every time you log in.
If you’d like to earn a little more interest, some online banks offer higher savings account interest rates than traditional banks. Just make sure your deposits are FDIC insured, which means that the federal government insures your account balance up to $250,000.
A money market account also pays higher interest than a checking account and allows you to spend the money when needed. It’s a nice blend of savings and checking account features.