Emergency Funds: How Much Should You Keep In Reserve?

The question is never about whether you should or shouldn’t have an emergency fund, but rather, how much of your resources should you allocate to it.

Life, for the most part, is unpredictable. You never know when you or someone you’re responsible for might need medical attention or legal assistance. It’s because of life’s unpredictability that you’re going to need to have cash at the ready to deal with these difficult situations.

But, before you even begin to craft your emergency plan, it’s important to be able to define what is a financial emergency and what isn’t. This allows you to decide much easier whether it’s time for you to rely on your emergency funds or not.

The danger of not being able to discern an emergency from an ordinary expense is that it’s easy to commit the mistake of using your emergency funds for something that isn’t an actual emergency, then being short on funds when the situation calls for it.

So, What Is A Financial Emergency?

At its very core, a financial emergency is an unforeseen expense that, if not dealt with in a timely manner, could lead to serious and immediate consequences. These will fall under three general categories:

• Home
• Health
• Occupation

For example, when you are involved in a car accident and are unable to pay for the medication needed to help you recover faster, there might be a chance that your condition could worsen without the proper treatment. Another example is if you get sued for causing injury to another — you’re going to need money, as well as seasoned personal injury lawyers like the ones found on mcquarrie.com, to represent you in court.

Again, an emergency is any expense that requires your immediate attention and money because failure to address it will have serious consequences now and in the future.

Emergency Fund Basics 

Once you’re able to discern between ordinary expenses and emergency expenses, you need to be able to set a goal. As a general rule, an emergency fund needs to be at least 6 months’ worth of your monthly expenses. So, if you spend $3,000 a month, you need to set aside $15,000 as your emergency fund.

If such a figure is beyond attainable means, then, according to two economists, a good amount to have in your emergency savings account is $2,467.

Emergency Funds In The Investment Context 

If you plan to invest in a volatile investment vehicle, such as the stock market or FOREX, you need to be able to take into consideration the chance that your trades might go horribly wrong. It’s also important to be able to prepare for a financial crisis, especially when you consider the fact that employment rates plummet during these difficult times.

You Might Also Want To Keep A Cash Cushion In Conjunction With Your Emergency Funds 

While they may sound like the same thing, they differ primarily in the purpose for which they are maintained. As previously discussed, an emergency fund is an account that is maintained so that you have money you can use when an emergency requires that you spend for it.

These are often expenses that are not anticipated and failure to address these expenses could lead to dire and immediate consequences. Emergency funds are especially needed by people who work in a shrinking industry, or those who have irregular paychecks, those who depend greatly on commissions, or if they are freelancers or contractors.

On the other hand, a cash cushion, while it may function similarly to an emergency fund in the sense that it is used during unforeseen situations, differs in its purpose. A cash cushion is a balance of money that is stored in your account that is used as protection against insufficient or late payment penalties as well as overdraft fees.

Another distinct difference is that emergency funds are often much bigger than cash cushions, which are just small amounts that are intended to serve as a leeway for when you are unable to come up with the funds to pay off your credit card dues, thus avoiding any overdraft penalties.

Why Is It Important To Differentiate Them?

It’s important to differentiate your cash cushion from your emergency fund in the same way that it’s important to separate your emergency fund from your savings. You need to be able to cushion yourself against unforeseen expenses as well as expenses that may prove to be too heavy to handle at the given time.

It’s also important to maintain both accounts so that you’re also able to prevent them from eating into each other. Each of these funds has a specific purpose and should only be used for their designated purpose.

So, it’s not enough that you’re able to save, you need to be able to determine whether a particular expense is worth digging into your emergency fund for. You have to have a cash cushion to avoid penalties when you commit a purchasing error. Remember that you need to be disciplined about your expenses. Even when you have the income to allow you to spend as much money as you want, wealth is as much about earning money as it is about saving money. If it’s not a real emergency, don’t use the funds that are meant for these situations.