Emergency Funds

Why have an emergency fund?
One of the core components of a healthy financial plan is an emergency fund. Many financial experts even recommend the emergency fund be your first financial goal. I agree with this sentiment. But why exactly should you have an emergency fund?

The main goal of an emergency fund is to cover unplanned expenses (aka emergencies) that arise so that you don't have to go into debt to cover those expenses. In particular, there are several different common major emergencies an emergency fund can cover:

• Car repairs and car replacement
• Medical visits and emergencies
• House repairs such as flooding and fires (if your home insurance doesn't cover or doesn't pay out immediately)
• Loss of job, or a loss of income do to disability, pregnancy, or some other emergency
• Expenses associated with family emergencies and tragedies
• Many, many other events that cost nontrivial amounts of money

So how much should you save up?
Ask 10 different financial experts and you will get 10 different recommendations, of which the most common are:

• Based on a number of months of expenses, typically 1, 3, 7, or 8 months
• Specific amounts, such as $5,000 or $10,000
• One year of expenses
• Whatever you feel "comfortable" setting aside or whatever is right for you

Some experts, such as Dave Ramsey, recommend a combination of the above in a step wise manner. He recommends first saving up $1000 in your emergency fund, paying off debt, then saving up 3 - 6 months of expenses. I agree with Dave with his methodology of first starting an emergency fund, paying off debt, then finishing up the emergency fund. But I disagree with the amounts.

Rather than first saving up $1000, I recommend to first stop living paycheck to paycheck by saving up one half to one month of expenses. Once you have it saved up, then you should be able to cover situations such as minor car repairs, buying a beater car if your car needs to be replaced, a doctor visit, a loss of job or disability for up to one month, and expenses associated with family emergencies. Keep half of your money in your checking account and the other half in either a traditional or money market savings account. This will help cover some emergencies where you don't have time to transfer the money from the savings account to the checking account and will prevent you from over-drafting in such an event. It will also prevent you from over-drafting if the timing of paying your bills doesn't work out exactly as planned and a large bill is paid the day before payday.

After you have paid off your debt, save 3 months of expenses. The three months of expenses would be able to cover the estimated average out of pocket maximum towards medical expenses (1) before health insurance pays out, loss of job or disability for three months, and cover some substantial house repairs. At this point I recommend to start saving 10% of your income towards retirement.

But your emergency fund still isn't complete yet. Why? Because 3 months of expenses doesn't cover the average duration of unemployment. From 1948 until 2008, the average duration of unemployment was between 7 and 20 weeks (2). If you save up 6 months of expenses, then you should be able to cover all of your expenses long enough to get a new job. It will also help cover many major house repairs and cover your expenses up until long term disability insurance kicks in, which is usually around 6 months (3). Once you have set aside 6 months of expenses, your emergency fund is complete.

References:
(1) http://www.goinsurancerates.com/health-insurance/out-of-pocket-expenses-series-maximum-limits/
(2) http://economix.blogs.nytimes.com/2011/06/03/average-length-of-unemployment-at-all-time-high/
(3) http://employeebenefits.about.com/od/ancillaryinsurance/a/LTDBasics.htm