A good savings plan should begin with establishing an emergency fund. How much should go in that emergency fund is up to you. The amount you need to save is dependent on a variety of factors including basic living expenses, debt obligations, and your family situation. A single person renting a one-bedroom apartment is going to have an emergency savings fund with a lower target amount than someone who is married, has three kids and owns in a five-bedroom house.
But before you start throwing money toward this fund, it’s important to know its purpose.
An emergency fund is established for these necessities:
Housing (mortgage or rent) and utilities
Maintaining a vehicle used as your primary source of transportation to/from work (or other costs associated with commuting to and from your job)
Basic medical bills
This idea is not for this fund to be a catch-all to cover your living expenses when your budget gets off track. It’s to be used for financial emergencies only.
What constitutes a financial emergency?
A financial emergency is when a life event happens that prevents you from being able to pay your basic living expenses. If your payroll department or bank made an error and you didn’t receive a paycheck as planned, could you cover those four necessities above? If not, you may need to dip into an emergency fund to get you over this financial hurdle.
I think of it as an event that jeopardizes your physiological needs, your ability to survive:
What is NOT a financial emergency?
Attending a sporting event or concert
New cell phone, computer or other toys
Clothing (beyond what’s necessary)
All of these expenses should be part of your savings plan. In addition to an emergency fund, you should have multiple additional savings accounts to cover clothing purchases, vacations, entertainment, and gift giving. These expenses, while not as reliable and consistent as a monthly utility, are a part of life so you still need to plan for them too.
Read our blog posts about opening multiple savings accounts and five questions to ask before opening a savings account for more information.
When You Dip Into Your Emergency Savings
Unexpected life events do happen. If you need to use your emergency savings, make sure you have a plan to replenish it as quickly as possible. The idea is to have those funds there, readily available, when you need them. You want your emergency savings fully funded so you have the money if life throws another whammy your way.
For many of my clients, their journey to financial success begins when they stop putting everyday expenses on credit cards and start building up their savings. Budgeting takes discipline and some immediate sacrifices, but the rewards are worth it. Making an emergency fund part of your plan means having peace of mind when life happens. And it always happens.