What is an emergency fund?

An emergency fund is a dedicated bucket of money. This “bucket” helps you cover unexpected expenses or a loss of income. Think of it as your own personal insurance fund. A few examples of unexpected expenses include:

• Car repairs
• Medical costs
• Home repairs
• Appliance replacement
• Pet emergencies
• Unexpected travel
• Unexpected gifts

Depending on how detailed you are with using a budget, you may already account for some of these “emergencies.” But even for the most detailed budgeter, there are going to be times when something unforeseen comes up. By regularly contributing to an emergency fund, you’ll be better prepared to handle whatever comes your way.

Should I fund my emergency fund in stages?

Yes. MoneySwell recommends saving for emergencies in three distinct stages of financial maturity: Security, Growth, and Independence. There are three interrelated reasons to fund your emergency fund in stages.

1. Accomplish Your Goal by “Chunking”: A huge body of research shows that we are more likely to accomplish our goals when we break them into smaller, more manageable pieces. Psychologists call this “chunking.” Imagine if we told you had to save an entire year’s worth of your salary. Now imagine we told you to save one paycheck’s worth. Which goal would you be more motivated to get started with? By creating three stages of an emergency fund, you’re more likely to build one in the first place.
   
   

   How large your emergency fund should be depends on your life stage.

2. Recognize Your Life Stage: When you’re 23 (for example), it’s likely your responsibilities will be less than when you’re 43. You may not have kids, a home mortgage, or other major obligations. By 43, you’ll likely want a larger safety net to protect the life you’ve worked so hard to build. Put differently, there’s no need to protect what you haven’t yet built. Therefore, it’s recommended to build your fund for the stage of life you’re in.
3. Balanced Your Priorities: Growing your emergency fund on an “as needed” basis gives you the ability to meet your other financial goals. For example, by creating a smaller fund now, you free up funds for other important financial goals. These may include paying down debt (which reduces interest costs) or funding your long term savings (which increases the time your investments have to grow). 

How much should I have in my emergency fund?

This is a matter of preference. A larger fund provides more security but at the cost of putting that money to other uses like paying off debt or long-term investing.

Look at the chart below. Column “A” represents the lower threshold and column “B” represents the higher threshold. Each row represents a given stage of financial maturity.

Financial Stage	A) Lower Emergency Fund Threshold	B) Higher Emergency Fund Threshold
Security	1 Month of Living Expenses	3 Months of Living Expenses
Growth	3 Months of Living Expenses	6 Months of Living Expenses
Independence	6 Months of Living Expenses	1 Year of Living Expenses

Lower thresholds (column “A”) may be a good choice if you:

• Have medium or high-interest debt and want to reduce your interest costs
• Have fewer financial responsibilities – like only having to care for yourself, have few “essential” monthly expenses etc. 
• Want to prioritize any extra money you have for long-term investments

Higher thresholds (column “B”) may be a good choice if you:

• Don’t have medium or high-interest debt
• Do have significant financial responsibilities – like dependents, a home mortgage, car payment etc. – and want to make sure you are prepared to meet those obligations
• Are already funding and are on track with your long-term savings goals

Why is an emergency fund so important?

Apart from the obvious benefits (having cash for unexpected expenses or as a hedge against a loss of income), there are three more surprising benefits of a solid emergency fund.

Avoiding the Debt Cycle

An emergency fund helps you get out of the cycle of debt…for good. Imagine you have high-interest debt. You put 100% of your extra income into paying this debt off. You’ve been doing this for months (or even years) and you’re finally about to pay your debt off. But then an emergency happens. Without an emergency fund, you will immediately be forced to take on high interest debt all over again. Now you’re in a vicious cycle.

But imagine an alternate scenario. You only put 80% of your extra money towards debt payments. For the remaining 20% you put it in an emergencies-only savings account. Of course you’re paying your debt off more slowly – and paying more in interest. But you’re also building a cash reserve. Now, when that emergency strikes, you can withdraw money from your emergency fund for free instead of having to take out more high-interest debt! This method may mean you end up paying less overall in interest. Not only that, you’ll be psychologically stronger because you won’t feel like a single emergency has the power to set back months of hard work. And that’s priceless.

Allowing Investments to Grow

A solid emergency fund can help your investments reach their full potential. Imagine you’ve put all your extra income toward investments. Your goal is to maximize your long-term savings. And, you don’t have an emergency fund. But you’re not worried! You figure, “No problem! If something happens I’ll just sell some stock.” While that will help you cover unexpected expenses, it doesn’t give you any flexibility. If an emergency strikes when your investments are slumping, you lock in those losses when you sell. Having an emergency fund gives you flexibility to sell your investments at a more optimal time.

Remember this investing adage: “Investing success comes from time in the market, not timing the market.“ But when you sell stock to pay for unexpected expenses, you’re reducing your “time in the market.” Instead, by having an emergency fund you’ll have the flexibility to ride the volatility of investments and maximize your long-term returns.

Peace of Mind

Just like an insurance policy your fund has value even if you never directly use it. It buys you peace of mind. As long as you have this fund, you can rest easy knowing that if you were to lose your job or incur an unexpected expense, you would be okay. 

Action

Now, follow the next steps in your MoneySwell plan to understand how to set up an emergency fund and get it funded.