Should you have an emergency savings account? If so, what kind of account is best? What’s the right amount to have saved? When is it ok to dip into it?
Who needs an emergency savings account?
First things first: everyone should have an emergency savings fund. Unexpected car breakdowns, health expenses, home repairs, and emergency travel happen to everyone, and having some cash to cover them when they come up will keep you from relying on credit cards and compounding an already difficult situation. Even more importantly, a reserve works to cushion you for a while against job loss, and gives you some flexibility in choosing job offers.
What is an emergency savings account, anyway?
Now let’s define an emergency savings account. This should be a very liquid (read: basically cash) account that is easily accessed if needed, but not part of your regular budgeting. It should not be a brokerage account: bad news tends to follow itself, so you don’t want to have to sell investments and possibly incur trading losses or tax gains, making a bad situation worse. It should not be a tax-deferred retirement account (IRA, 401k or similar), since withdrawing from those will lead to taxes AND penalties. An online savings account is perfect for this kind of thing. These are FDIC insured (up to $250,000 per depositor) accounts that link to an existing checking account, making transfers very easy, and pay a bit more interest than a regular account at your local bank. Just remember, savings accounts are generally limited to 6 withdrawals or outgoing transfers in a month. You can compare current offers here: http://www.nerdwallet.com/rates/savings-account/. As long as the account offers FDIC insurance and ease of use, it’s a great choice.
How much should be in there?
So how much should you save? First, calculate a month of living expenses: rent or mortgage, utilities, insurance, car payments, groceries, all the things you can’t really put on hold. Aiming to reserve somewhere between three and six months’ worth of expenses is best (closer to three for a steady two-income household, six if there’s only one source of income, if income is irregular, or if you have kids or pets). Some clients feel more comfortable knowing that nine to twelve months’ of living expenses are covered. You can certainly save even more than that if you prefer, but with interest rates being so low, a large cash balance is probably put to better use elsewhere (accelerating debt paydown, starting an investment program, philanthropy, etc).
I can't save that much!
If you’re starting from scratch and overwhelmed at the thought of getting to the three month mark, just remember that it won’t happen all at once. Start small and just keep going. Keep an initial goal of just $1,000 in sight, and track your progress. Even $50 per paycheck is a good first step, and as always, automation is your friend: ask your payroll department at work whether you can set up multiple direct deposits, and divert a small amount to your savings account each pay period. If that’s not an option, set up the automatic transfer yourself to coincide with your pay periods. Either way, when you get used to the lower take-home amount, increase the amount diverted to savings little by little. It’s not all-or-nothing: just do the best you can, and don’t let the perfect be the enemy of the good. Even if you have just a few hundred dollars saved the next time a crisis occurs, that's a few hundred less you will have to borrow.
When do I use it?
What constitutes an emergency? My definition: any unavoidable expense that you can’t cover with regular cash flow. Fixing the car or the boiler, getting a root canal, emergency veterinary care, buying food and paying rent when you’re between jobs and unemployment/severance isn’t enough - that’s what this account is for.
Savings of any kind - emergency, retirement, vacation, or anything else - buys you flexibility in the future. Establishing an emergency fund is one of the most important things you can do to create financial stability for yourself. It will decrease your reliance on consumer debt, allow you to hold out for a better job offer, and ultimately save you money even if no job loss occurs. I won't pretend building up a reserve is fun or exciting - after all, it's basically just money you hope to never have to spend, and that by definition won't be spent on anything fun - but the feeling of security it provides will hopefully make up for the more enjoyable expenses you may have to cut back on to get there.