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Last month we started talking about the Dave Ramsey method and paying off debt in baby step 2.  Today we're looking at steps 1 and 3 - the emergency fund.  I think it can be really tempting, at any stage, to skip the emergency fund.  It seems better to pay off debt or save or Christmas or invest in retirement.  While those are all good things, the importance of the emergency fund cannot be overstated.

What is an emergency fund?

An emergency fund is just the money you put aside to deal with any financial emergencies.  Pretty straightforward - it is your financial buffer when things go wrong, so you don't have to go into debt and put things on a credit card.  Because things always go wrong, that's life.  Having this buffer offers peace of mind and acts as a giant safety net between you and life.  It's not the same as your savings account and the money shouldn't be used in the same way you use savings - think of it as insurance, not an investment.  We're talking true, unexpected emergencies like job loss or a major medical emergency, not the fact that you were surprised Christmas is in December.

Why should you have one?

Most Americans cannot pay cash for an emergency.  And I don't just mean 'we need $10,000 for a new roof' emergencies - I mean that most Americans cannot pay cash for a $1,000 emergency.  64% in fact.  And 7 out of 10 households live paycheck to paycheck.  That's a dangerous cycle, even if part of that paycheck is going into an employer sponsored 401(k).  The biggest threat to your retirement savings is having an emergency without an emergency fund.  Because when one comes up, you end up using those retirement savings to pay for that emergency and then what?  You're trying to play catch up until it's too late.  Being one emergency away from financial disaster should terrify you.

How much should be in an emergency fund?

The amount you should have in your fund depends on where you are in your financial goals.  The most important thing is getting and staying out of debt, so if you're still in the 'pay off debt' baby step, then you should just have the minimum $1,000-$2,000 in your emergency fund.  That's step one.  Having a small amount may seem scary, but that's kind of the point.  You need to be motivated to pay off debt and having a small savings account is one way to do that.

If you are debt free, the amount should be 3 to 9 months of operating expenses.  Expenses would be defined as just the bare bones of necessities - ask what you would need to live for 3 to 9 months if you lost your job.  If you didn't have income coming in, you wouldn't be eating out or spending on Netflix, for example.  How do you decide between 3 and 9 months, or somewhere in between?  It depends on your career field and how employable you are.  It is a fact of life that it's harder to get a job if you are older, so you need more months to search.  Likewise, if you're a freelancer without a steady paycheck, 9 would be a better option.  If you are younger and have a degree that makes it easy to find a job (tech or finances, for example) then you could do just the 3 months.

Use your budget to find your operating expenses for the month and multiply that number by the number of months appropriate for your situation.  That's your emergency fund.  And since we treat it as insurance and not an investment, we don't want to do anything risky with it or have it somewhere that isn't easily accessible.  Keep it in a savings or money market account where you can get it within a day or two without fees or hassle.  This is your fully-funded emergency fund, never to be touched unless it's dire!

Do you have an emergency fund?