Why You Need an Emergency Fund

I learned this lesson the hard way: Everybody needs an emergency fund. Not just those of us living paycheck-to-paycheck or coming fresh out of college. We all need money set aside for a rainy day.

Why?

Because you could lose your job or your refrigerator could die or you might have to get an emergency root canal. And if you don't have enough cash on hand, you don't want to find yourself looking around the house for valuables to pawn, racking up credit-card debt or contemplating a payday loan.

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In my case, I had a surprise tax bill. I got a refund the previous year, so I didn't expect to owe the IRS -- especially not close to $3,000. Plus, my husband and I had been paying down high-interest debt. That left our account balance pretty low at the time our accountant finished our tax returns -- only one week before the filing deadline. To top it off, I had a quarterly estimated tax payment due at the same time.

So I wiped out my account to pay Uncle Sam and relied on birthday cash from my mom to buy groceries until my next paycheck arrived. It was a terrible feeling being broke -- even if it was just for a few days.

No more excuses

I have only myself to blame, though. Equal parts procrastination and denial had prevented me from creating an emergency fund.

While my husband was in graduate school and I was the sole income earner, my excuse for not setting aside cash for a rainy day was that I didn't have extra cash (the procrastination part). Once we both were working, I figured we had enough left over in our bank account at the end of every month to cover minor emergencies (the denial part).

Maybe you've been making excuses, too. Here are some common ones, and why they don't hold water.

Excuse #1: I can't afford to set aside money

If you think you don't have any spare cash in your budget to save for an emergency fund, where do you think you'll get the money to pay for an actual emergency? Selling plasma? Hocking all your belongings on eBay?

You need an emergency fund the most when you're just starting out or living paycheck to paycheck, says Jan Dahlin Geiger, a certified financial planner with LongView Wealth Management in Atlanta. An unforeseen event could devastate your finances and force you to borrow money. You won't get ahead financially if you're in debt, Geiger says.

The conventional wisdom is to have enough set aside to cover three- to six-months' worth of living expenses. That doesn't mean you have to stash that much cash at once. Nor does it mean you have to have a big salary to have enough to spare for an emergency fund. Saving is a function of discipline, not income, Geiger says.

A good way to get started is with a tax refund (most taxpayers get one).

You probably have even more money to spare and don't realize it. If your federal tax refund was anywhere close to the average of $2,600, you probably are having too much withheld from your paycheck. Use our quick and easy calculator to see how much you can add to your monthly paycheck. Put that extra cash into your emergency fund each month.

Then track your spending for a month to figure out where you can cut back, and divert that money to your emergency fund. If you have direct deposit at work, you can have your employer deposit a portion of your paycheck into a savings account. For help finding ways to keep more cash, see Save Money on Practically Everything.

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Excuse #2: I can use a credit card for emergencies

In a pinch, you always can use a credit card, right? Wrong.

While in college, a friend gave me a ride home during a school break and his car broke down while we were driving across southwestern Virginia. It was a small town with only one mechanic -- who didn't take credit cards. My friend used his debit card to empty out his account, but it wasn't enough to cover the bill. So he had to leave his hunting bow as collateral until he came back with more cash on his return trip to our university.

You can't always count on your credit cards as your emergency source of cash -- nor should you. If you use a credit card for an emergency, Geiger says, "what you're saying is you want to tread water financially. That's why you have an emergency fund -- so you don't have to use debt."

For example, if you charged $1,000 to a credit card with an 11% rate (about the average for low-rate cards now) and paid just the minimum each month ($40), it would take you six years to wipe out your debt and you'd pay about $258 in interest.

Excuse #3: I have other sources of cash

If you think your retirement account is a good source of emergency cash, think again. You'll pay penalties and taxes at your income-tax rate if you tap your IRA or 401(k) before retirement.

For those of you relying on a home equity line of credit, be careful. If you already have a line of credit, it might not be worth as much now because of falling home prices. You may have been approved two years ago for, say, a $50,000 line of credit. Now you might have only $10,000 in equity.

If you don't have a line of credit but "are dependent on being able to borrow money on a moment's notice, you could be in for a rude surprise" Greg McBride, CFA, senior financial analyst at Bankrate.com. Lenders are offering fewer lines of credit or freezing them altogether, he says.

The only people who should be relying on a home equity line of credit are those whose only debt is their mortgage, who will be disciplined enough to pay off the line of credit as quickly as possible and who have plenty of money in investment accounts (to cover the HELOC if necessary), Geiger says.

Where to put your money

The place to park emergency savings is in a bank money market or savings account, McBride says. The interest rates on these accounts are not great now, but your principal will be safe and you'll be able to access your money easily.

"You're not putting money into a savings account to make you rich," McBride says. "You're putting money in the savings account because it's a buffer from high-interest rate debt when unplanned expenses arrive."

To find money market and savings accounts with the best rates in your area, American Express Bank, Colorado Federal Savings Bank and NewDominionDirect.com, all yielding 1.5%. No, you won't get rich off that rate, but it's better than what you'd get at most brick-and-mortar banks. Plus, the account has no monthly fees and no minimum balance.

Some online banks don't provide ATM cards and checks for their interest-bearing accounts -- only online transfers to your regular bank account. So if your car breaks down in the boonies where you can't access a computer to transfer funds, your emergency fund won't be of much use.

Some financial planners recommend money market mutual funds. But these come with fees and minimum investment requirements. For example, Vanguard, which has the lowest fees in the industry, has an average expense ratio of 0.14% on its money market funds plus a $20 annual fee on accounts with less than $10,000 and requires a $3,000 minimum investment.

So no more excuses. I stopped making them and opened a money-market account after that surprise tax bill. Now it's your turn to open an account today and start saving so you'll be prepared not if, but when a rainy day comes.