An emergency fund isn't just needed in times of natural disaster. Job loss or unexpected medical expenses can also drain your bank account quickly. Start building your rainy-day fund before the clouds start to appear.
However, in addition to preparing for the unknown, you should also prepare for known unknowns, or expenses that are somewhat predictable--such as car repairs or replacing a major appliance. Having money set aside for these types of situations can give you peace of mind now and make a world of difference if and when you actually have to use it.
Let’s look at what types of expense should—and shouldn’t—be dealt with by an emergency fund.
“Known unknowns” are situations that we can partially anticipate—so this is the type of expense that should not be dealt with by an emergency fund. These situations are on our radar, even if we don’t know exactly when they will happen. For example, if you own a vehicle, you know that at some point it will need repairs, just like you know that your home will eventually need a new furnace or that your pet will eventually need a visit to the vet.
A good budgeting exercise is to make a list of all the known unknown expenses you can think of. Then compare the list to your budget and see if there are any categories you’re not currently saving for. Odds are that there are probably a few areas your current budget doesn’t cover, so you’ll want to adjust it to include these additional categories.
“Unknown unknowns”, which are the types of expenses that emergency funds are truly designed for, are situations that take us completely by surprise. We don’t know when they will happen, how much they’ll cost or even what they will be until they’ve happened. For example, a family member could suddenly fall ill and you need time away from work in order to care for them. Hopefully, you’ll never experience an unknown unknown, but if you do, the knowledge that you have an emergency fund to cover additional expenses will undoubtedly help to ease a stressful situation.
Although your emergency fund is not intended to cover known unknowns, if one of those situations has spiraled into a bigger-than-expected expense, that is something your emergency fund would be able to cover. For example, although you have a budget for regular vet visits, you discover that your beloved pet needs surgery, which will cost $2,000. Or you might have savings to cover your car insurance deductible, but it takes three months longer than expected to receive reimbursement from the insurance company. In these situations, it makes sense to dip into your emergency fund to cover an underestimated known unknown.
Emergency funds vary widely from person to person. The regular recommendation is six months’ worth of expenses, but some prefer having nine months’ or a year’s worth tucked away. It’s a significant amount, as it should be—it’s what you would be living off if you didn’t have an income for an extended period of time. Whatever amount you choose, it’s a hefty savings goal and it will take time to meet it, but it will make all the difference in tough times. When setting your emergency-fund savings goal, consider the following:
Ultimately, your emergency fund is about your peace of mind. Design it to fit your specific needs.