Why do you need an emergency fund?
It tends to be last on the list of financial priorities, but an emergency fund 鈥斅爉oney set aside for unexpected expenses such as聽medical costs, surprise home or car repairs, travel, or job loss 鈥斅燾an considerably improve your overall financial situation.
The amount needed in an emergency fund varies from person to person and depends on the situation, but a general rule of thumb is that the fund should equal three to six months of expenses. Variables that could affect the needed amount could include having a spouse who聽does not work, having a seasonal job, or having a very conservative or aggressive risk tolerance.
Why is an emergency fund so important? Because having one ensures that you can pay for unexpected costs without turning to sources of funds that lead to harmful financial outcomes.
Few good options
Not having an emergency fund doesn鈥檛 mean you can鈥檛 pay for emergencies, but it does mean that money will have to come from somewhere 鈥斅爑sually a place that you鈥檇 be better off not touching. Here are some of the typical sources of funding people tap when they lack an emergency fund:
:聽Let鈥檚 say you聽had to withdraw $12,000 today from a retirement fund for an emergency. In 30 years, that same $12,000 would have been worth almost $52,000, assuming a modest 5% return and not making any adjustments for inflation. That鈥檚 money you won鈥檛 have when you retire, and it鈥檚 because you didn鈥檛 have a sufficient emergency reserve.听Depending on the situation and聽, you also may have to聽聽on the amount you withdraw.
Credit cards:聽Simply put, interest rates on credit cards are high. Taking on the extra debt can affect your credit score, and if you鈥檙e already in a sensitive financial situation, using credit cards can lead to potential late fees or worse.
Family or friends:聽It can be a big mistake to depend聽on anyone else to bail you out of a financial hardship. That person might聽not be able to help, or it might聽place stress on the relationship.
As you can see, these aren鈥檛 great options for paying for emergencies. Building an emergency fund is clearly preferable.
Benefits of having an emergency fund
Spending control:聽Keep your emergency fund in a separate account and away from your day-to-day sources of funding. When聽you don鈥檛 have聽easy access to your emergency fund聽via debit cards or other means, you decrease the chances that you鈥檒l聽dip into the account. You also can easily determine whether you need to save more or whether聽you have reached your funding goal by having a separate, stand-alone balance.
Peace of mind:聽There鈥檚 nothing exciting about carrying a spare tire in your trunk, and there鈥檚 nothing fun about changing one. But you鈥檙e thankful it鈥檚 there when you really need it. This same logic applies to having an emergency fund. It gives you protection from unplanned financial events that often are main causes of stress.
Having an adequate emergency fund is as important as building your house on solid ground. By maintaining such a fund, unforeseen costs can be quickly absorbed without compounding the problem by adding聽debt to the equation. Creating an emergency fund is one of the biggest components to having financial peace of mind and increasing your chances of reaching your long-term financial goals.
聽is a financial advisor with聽.听Learn more about Christopher聽on NerdWallet鈥檚聽. This article first appeared at .
