How To Get Your Finances Under Control – Step 5 Establish an Emergency Fund

By glblguy

Emergency Fund

Proverbs 27:12 – A prudent person foresees the danger ahead and takes precautions.
The simpleton goes blindly on and suffers the consequences.

This is part of the series How to Get Your Finances Under Control

Now that we have a budget in place, we need to start an emergency fund. Following a budget and having an emergency fund in place are the two most critical steps in getting your finances under control.

An emergency fund is the fund you will use to handle emergency or unplanned expenses. In step 4, we established a zero based budget, in that our income minus expenses equaled zero. Or in other words, every incoming dollar had an expense line item in the budget. Also remember, we did our budget on paper prior to the actual budget month. So how do you handle unplanned expenses such as the car breaking down, the dish washer breaking or the hot water heater unexpectedly going out? How do you handle your 10 year old coming home from school and asking for $20 to go on that field trip tomorrow that you didn’t budget for? The answer is the emergency fund.

If you’re like I used to be, whenever something like this happened, we used our credit card. An emergency fund allows you to fund these unexpected items without using a credit card.

Start out with an initial emergency fund of around $1000. There is no correct number here, as the amount needed will be driven by things such as how old your cars are, how many children you have, etc. I keep about $1500 as that is a number that makes me feel comfortable. Remember, we have 6 kids so our emergencies are sometimes a little more expensive. I wouldn’t go below $500, and more than $2000 is too much.

At this point many of you are asking, too much? I’ll explain later in this series, but part of getting your finances under control is going to be getting rid of your credit cards. For now though, just hang in there…I promise I’ll explain.

If you have you emergency fund already, great, if not start aggressively saving one today. We want to establish this emergency fund as quickly as possible.

Dave Ramsey in his Total Money Makeover Book recommends $1000 dollars initially as part of Baby Step #1 and then once you’re debt free, bump it to 3-6 months worth of expenses.

Your emergency fund should initially be kept in a separate account and not with your spending money. This reduces the temptation of spending it. I actually keep mine in two separate accounts. Half in a CapitalOne High Yield Money Market account and the other half in an INGDirect savings account. With the CapitalOne account, I have check writing privileges. This is very convenient when you have an emergency that you have to pay for now. Transferring your money from your INGDirect takes about 3 days. For an emergency fund, that is a too long for me. Both of these are high interest bearing accounts and both banks have great online banking and customer service. If you are interested in an INGDirect savings account, contact me, and I will send you a referral. You’ll get $25 and I’ll get $10 when you sign up.

It doesn’t matter where you store your emergency fund. Remember it’s not an investment, so you want it to be liquid and relatively easy to get to, but not too easy.

Defining what constitutes an emergency. I would recommend writing it down. For us it is simply any unplanned expense that can’t wait until the next budget month to address. If you don’t define what an emergency is and agree on it with your spouse, things like big screen TVs, iPhones, that cool new widget, etc will become emergencies.

A couple of months ago, I took my car (a 2001 Nissan Sentra) in for an oil change. Turns out, two of the tires where wore through to the steel and my front brake pads where worn to the metal. So a free oil change turned into a $600 expense. Was I happy, of course not, but I wasn’t worried. We used our emergency fund to pay for it. There was something really awesome about driving away from the dealership with new brakes and tires that I payed cash for. I didn’t go further into debt, it was a great feeling.

Life throws you curve balls everyday, sometimes they are little inconvenient ones and sometimes they are really expense and inconvenient ones. The emergency fund allows you to deal with these unexpected expenses without going further into debt and without blowing your budget.

In Step 6, we’ll begin the debt snowball and begin the process of obtaining true financial freedom, eliminating debt.

For those of you who already have emergency funds, where do you have yours? How much of an emergency fund do you have and why that amount?

12 Responses (including trackbacks) to “How To Get Your Finances Under Control – Step 5 Establish an Emergency Fund”

  1. Lulu Says:

    My emergency fund is at ING. It is depleted right now because I just had to use it up but I am slowly building it back up.

  2. glblguy Says:

    I think ING is where a number of PF bloggers keep their savings/emergency funds. I’ve been very happy with them thus far.

  3. ChristianPF Says:

    I too love ING, they aren’t the best rate out there, but I think they have the best interface and service.

    In regards to your post – Here is an excerpt I wrote about using your emergency fund to put more money in your pocket (sorry, I don’t feel like retyping it)

    You start putting $100 a month into a high-yield savings account. This will not generate much income, but it will do a whole lot better than spending the money.

    After a five months, barring no emergencies, you will have $500 in your high-yield savings account earning a nice interest rate. Now you can call your car insurance company and ask them to raise your deductible from from $100 to $250. Since you have $500 set aside for an emergency, you will now be able to afford the $250 deductible.

    The good news is that when you raise your deductible, your insurance bill goes down. Now that you are saving $120 a year on your insurance bill, you can add that to your emergency savings. Instead of saving $100 a month, you can now save $110 a month ($120/12 months=$10) with no extra money out of your pocket.

    Now that you are adding $110 a month to your emergency fund each month, it will grow even faster. In a few more months, you will reach $1000 balance. You can call the insurance company again and ask them to raise your deductible to $500. Again, this will lower your insurance bill even more. Add the difference to your emergency savings and keep this cycle going.

    As you can see doing this over and over again will save you money, while expanding your safety net. Your bank account will be growing at a faster pace and you will have more peace of mind.

  4. glblguy Says:

    @ChristianPF – Great, great idea!

  5. RobY Says:

    Hi Larry… I’m really enjoying your blog. It’s nice to see real content and your real life examples.

    You mention brakes above which remind me of a recent experience I had. I don’t normally take my car to the dealer for servicing but I recently had a small issue that required me to go direct to the dealer. As expected (and smart business too), they check out my entire car (Ford Explorer) and found other things wrong. The total estimate on brake related work was over $1,000 and they issued a stern warning about the risk of not fixing it immediately. I courteously declined.

    I did however take the warning seriously and took my car to a discount brake shop the next day and got their opinion. I spent $400 instead of $1,000. Although the parts weren’t from the dealer, I want to point out that I went with an upgraded option (not the cheapest they offered) that was equal to the dealerÂ’s specs.

    In addition to better prices on what I had done, I also saved money by what I didn’t have done. The second brake shop told me a few of the things the dealer wanted to do were not needed right now. They had 2 guys crawl under just to make sure. Also, they said that yes I should have the brake job done now but it wasn’t nearly as urgent as the dealer lead me to believe (I probably could have used it as is safely for 6 more months).

    My point to all this is to get second opinions for major expenses. The easy choice would have been to say “just do it”. It is often hard to decline… I personally don’t like telling someone no. But in this case I was able to recognize a well greased (pun intended) marketing machine working on me. From that perspective it made saying no easy because it was no longer personal. I knew they were acting in their best interest and I have a responsibility to myself to act in my best interest. Beside, they would always take me back later if the second quote was too high.

  6. glblguy Says:

    Rob, really good point. I always get a second opinion. I cheat though on my cars, I am friends with the owner of the dealership so I don’t get the normal hassle :-) Get a good discount too ;-)

    To add to your suggestion, beyond getting a second opinion you can often use the second estimate to negotiate the price. It is surprising the number of people willing to negotiate.

    Thanks for visiting Rob and for commenting!

  7. Ron Says:

    I have two emergency funds….sort of.

    My first emergency fund has a dual purpose. Each payday, money is transferred to it for annual bills like car insurance, eyeglasses, car registration, yearly check up for the dog (the most expensive medical expense at my house each year) and stuff like that. Life has also taught me that when something major breaks in my house or on one of my cars, it’s usually about $1000 bucks to get going again. So, I have $2000 sitting there for those things. I also use this account to save up for things I want to do in my house, like new carpet.

    My second fund is for true “rainy day, I’ve lost my job, I don’t know what’s going to happen next” emergencies. I have many months of expenses saved up there and, thankfully, I’ve never had to touch it. My goal is to have one year of expenses in this fund and then I’ll leave it alone.

    The peace of mind in having these types of savings is worth more to me than a new suit or flatscreen TV (although I’d really love one of those).

    Great blog, by the way.


  8. MITBeta Says:

    Like Ron, I also have a few different funds:

    1. One fund is simply a balance in the Money Market account connected to my checking account. I always have a couple of thousand dollars here for emergencies.

    2. A second fund is an accumulation of one time annual expenses like life insurance, disability insurance, car insurance, homeowners, car registration, gift giving, certain taxes, etc. This fund currently resides in a 2nd Money Market account that is not an overdraft account for my checking (in other words I have to transfer money when I need it…) but will soon reside at ING.

    3. A CD ladder of approximately 3 months worth of expenses (which I plan to add to over time). I have 5 CDs, one set to mature each year. I can cash these CDs out at any time and pay a penalty of up to $25. They have all already earned more than that, so interest is 100% bonus at this point.

  9. glblguy Says:

    @Ron and MITBeta – Thanks for the comments.

    I keep mine in two accounts, but only because I was trying to evaluate CapitalOne and ING. Need to combine them at some point.

    MITBeta, curious why you have CDs? The rates on the high interest savings are about on par with CDs at this point and the money is more liquid with no penalties.

  10. MITBeta Says:

    I don’t know how long high interest savings accounts will be at the rates they are. So I can get a guaranteed 5.35% on CDs. Plus, as you said in your question: they aren’t as liquid, so they are less tempting to use for minor emergencies. The small margin on the interest rate over the high interest savings account is high enough that the penalty is very small if I ever need to pay it.

    I will be re-evaluating the best place for the money every time a CD comes due.

  11. glblguy Says:

    Makes sense, thanks!