Establishing an emergency fund is one of the central components of healthy personal finances. Designed to help you weather unexpected storms, many financial experts recommend insulating yourself from emergencies by putting aside at least three months’ worth of expenses. Saving money for an emergency fund is one side of the ledger, but how can you know when is the right time to dig into this set of savings?
For some, to paraphrase the famous Supreme Court Justice Potter Stewart’s definition of obscenity, they will know it when they see it. For others, the answer is not quite so straightforward, and therefore, a few guidelines can help determine if the time is truly right. Here are three and a half questions to ask in order to understand if now is the right time to use your emergency fund.
What Is an Emergency Fund?
To understand when the time is right to deploy emergency capital, it is important to understand what an emergency fund is. In short, an emergency fund is a pot of money that is meant to be left untouched unless there is a sudden, unplanned expense.
An emergency fund should, therefore, have a number of important qualities:
(1) It should be highly liquid: You want to make sure that the funds can be accessed immediately. You may need to make a payment without delay, and finding a buyer for an illiquid asset could leave you high and dry for a bill that needs to be paid immediately.
(2) It should not be used for planned expenses: You might be tempted to dig into your emergency fund to go away with friends for a weekend or pay a little extra for a wedding present. Resist this temptation. Once you allow yourself to start using this fund for non-essential purchases, it will be easy to continue treating it like a regular savings fund.
(3) It should contain at least three months’ worth of expenses: A common recommendation is to have between three to six months’ worth of expenses set aside. This may seem like a large number, which is why it is important to make regular contributions to your emergency fund as a part of your monthly budget until you have accumulated your desired amount.
Having this fund will allow you to pay for emergencies without taking on credit card debt or a personal loan. The high interest rates that are a common component of these types of financing can make the overall obligation increase fairly rapidly, pushing you into a spiral of debt that can become difficult to escape from.
What Is an Emergency Fund Used For?
While an emergency fund should be used for emergencies, it is sometimes hard to tell when you should break open the piggy bank.
To help you understand if this is an appropriate time to dig into these funds, start by answering these three and a half questions:
(1) Was this unexpected? Some occurrences are impossible to anticipate in advance. Your car could break down, your water heater could burst, or you could experience a sudden illness that prevents you from working. These could happen in an instant and require you to use your emergency fund.
On the other hand, joining your friends for a destination wedding is something that has likely been on the calendar for a few months, at least. This should give you plenty of time to start saving for the plane tickets, accommodations, and your outfit for the wedding. If you can budget for and work toward this goal, it should not be a reason to utilize your emergency fund.
(2) Is this a necessary expense? Continuing along with the above example, fixing your car, repairing your water heater, or paying bills when you can no longer work would all qualify as a necessary expense. However, there might be ways that you could avoid accessing your emergency fund. This leads us to the next question, which really is a subset of this one.
(2.5) Are there alternatives available? Though every situation is different, there might be creative avenues for you to find alternatives to emptying your emergency account.
For instance, if there are good public transportation options where you live, or you do not really need your car on a daily basis, maybe you could go without a vehicle until you have saved up enough money to fix it. Similarly, while making repairs to your water heater is essential, maybe you have sufficient funds in your checking account to make this payment without endangering your other monthly obligations.
Now, about that wedding. While it is probably appealing, is it really necessary for you to attend? If it is, take the months beforehand to look into your budget to figure out which expenses you can cut back on in order to save up to join the wedding party.
(3) Is it an urgent expense? Urgency is another aspect you should ask yourself. For instance, if you can spend the next few months or years saving up for this need, then that is how you should proceed. Budgets function as a financial roadmap, allowing you to plan ahead for your future purchases. If your potential purchase can fall into this category, consider putting it off until a later date after you have saved up the money required.
However, do not forget that you built this fund for a reason. If this expense requires an urgent use–and you have determined that it is necessary and no (good) alternatives exist–then you can and should deploy your emergency fund.
Conclusion: Refilling Your Fund
The purpose of an emergency fund is to help you navigate potholes on the road of life. For this reason, refilling its coffers after you use it is just as essential as creating one in the first place.
Just as you had a plan to create a fund, you should also devote funds on a regular basis to refill it. Hopefully, you will never need to use your funds, and the monies you have set aside will remain untouched (while gaining interest).
However, the unexpected, the necessary, and the urgent can and do occur. Make sure you are prepared for them throughout your life. Not just the first time, but every time.
Learn money management and access data-driven stock insights with TipRanks.
