Wednesday, December 12, 2007

Choosing an Emergency Fund

After writing yesterday's post about moving my Emergency Fund to HSBC, I was interested to read what Paid Twice had to say this morning in her post describing her family's rationale for choosing a $1,000 Emergency Fund.

$1,000 is the most commonly recommended size for a starting Emergency Fund, largely based on the popularity of Dave Ramsey's 7 Baby Steps:
  1. $1,000 to start an Emergency Fund

  2. Pay off all debt using the Debt Snowball

  3. 3 to 6 months of expenses in savings

  4. Invest 15% of household income into Roth IRAs and pre-tax retirement

  5. College funding for children

  6. Pay off home early

  7. Build wealth and give!
    Invest in mutual funds and real estate
The idea is that $1,000 should be enough to cover most emergencies that would otherwise derail your financial plan in the early stages.

I have a $1,000 Emergency Fund. I started building this amount in May of this year, and crossed the $1,000 mark in October. For me, the decision of how much to save for emergencies was largely based on my 2006 tax return. I had under-estimated the amount of income tax I owed for the year, and when April 30 came around, I found myself with a $1,400 tax bill to pay. At the time, I had no savings (aside from my retirement investments), so this amount went straight on my line of credit. This represented an instant 6% jump in my revolving debt, all due to the fact that I was living completely paycheque-to-paycheque. Having a $1,000 buffer in savings would have made a huge difference.

Until this year, I've never had an Emergency Fund. Sure, there have been times when I've had $1,000 or more sitting in my account for a month or two, but it's always been spoken for, with a specific purchase (or debt paydown) in mind. Now, my savings and debt reduction are completely separate from my Emergency Fund. That $1,000 has no strings attached, and will only be used for an unexpected expense that I have no other way of covering. Over time, I'll gradually build this amount (it currently sits at $1,105.28), but I'm largely going to ignore the growth above $1,000, in order to avoid thinking of this as money that I can spend.

The other key piece of my safety cushion puzzle is my Freedom Account. This is the account that I use to cover predictable periodic expenses, such as car repairs, gift purchases, and license renewals. In the past, all of these expenses have generally qualified as minor emergencies, and have gone straight on a credit card. By putting aside money from every paycheque in my Freedom Account, I'm basically redefining what constitutes an emergency, and leaving my Emergency Fund to cover the truly unexpected expenses.

In my mind, I have $1,000 saved up for minor emergencies. That's more than I've ever had before, and it's an incredible boost to my feeling of security to know that I have anything saved up as a safety cushion.

What's your Emergency Fund strategy?


Anonymous said...

An important component of an emergency fund for me is "cash in the house". I have a few hundred dollars in twenties in the safe for when there is an extended power outage or the bank machine network goes down and credit cards become less than readily accepted.

mcb said...

I don't really have one right now, though I know I should. I do however have a "freedom account" for things like insurance, clothes, gifts and auto maintenance. I don't know how I ever lived without that account.