Millionaire Rule #5

Save an Emergency Fund
What would you do if you car broke down tomorrow and needed major repairs? How would you pay for it? What if you or a family member got hurt and the insurance company (or worse yet doctor) sent you a bill? Do you have enough to meet your co-pays and deductibles?

Unexpected expenses pop-up every day and it is important to have money set aside to pay for them. Keeping an emergency fund that is large enough to meet these expenses is an absolute necessity. I don't want to sound all gloom and doom, but bad things happen so be prepared.

There is a lot of debate among personal finance writers about how much spare cash should be stored in an emergency fund. There seem to be two primary camps, one advocates a large fund that is equivalent to several months of a families net take home pay. Kathy M. Kristof of the LA Times wrote the article It's Time for an Emergency Fund that says, "Pretend that tomorrow, for whatever reason, you are not going to be able to work for six months and the stock market is down 15%." From here it goes on to suggest keeping at least 3 months worth on income in a savings account.

The other prevailing take on how much to save is to keep a few thousand readily accessible. J.D. at the blog Get Rich Slowly writes in his post How Much in an Emergency Fund?, "there are few catastrophes that would ever require you to come up with more than a couple thousand dollars on short notice. Insurance will mitigate many problems. For everything else, there’s time to obtain capital: to tap into home equity, to sell stocks, etc." Those in this camp would expect to keep $1,000-5,000 in liquid savings and possibly open a home equity line of credit to supplement the savings.

Both approaches seem equally valid, but which you choose should reflect your own situation. I feel very secure in the stability of my employment. I also have insurance that covers short term disability. Because of these two facts, I plan to have a lean emergency fund that is enough to cover my insurance deductibles and little else. My maximum out of pocket expenses for my health insurance is $4,000 per year so I will use that as my benchmark for a major catastrophe. Over the next couple of years, part of my financial goals will be to save a little bit each month until I reach this level.

The next major decision is where the money should be kept. Most importantly, the money must be readily accessible when it is needed. It would be counter productive to tie your emergency fund cash up in a Certificate of Deposit (CD) which keeps it locked up for months at a time. It is also important that the money is able to keep pace with inflation or it will quickly lose buying power. Local banks and credit unions rarely pay a high enough interest rate to keep pace with inflation. Another consideration for emergency funds is that they should not be invested in stocks or other volatile investments. The last thing you want is for the value of your account to have plunged right when you need it the most.

Based on these considerations, it seems that money market funds and high interest online accounts seem to be the best savings options. I selected one of these high interest online banks for my emergency fund because it has the added security of FDIC insurance on the deposit which a money market does not. Rates are currently competitive with short term CD's and the money can be transfered into my checking account in no more than 3 days.

The important thing to take away from Millionaire Rule #5 is that bad things happen when we least expect. An emergency fund is the best way to make sure you are always prepared for whatever may come your way. This post is the fifth installment in my series Ten Simple Rules to Build Wealth. If you Aspire 2 Wealth like me be sure to read the rest of the rules and subscribe to my RSS feed.