Before you save for other goals, such as retirement, home, or a new car, it is imperative that you establish emergency savings accounts, typically called emergency funds. This is an amount of cash that you maintain in separate savings accounts just for emergencies. These accounts will be used to cover unexpected expenses such as medical and dental bills, household repairs, automobile repairs, and especially household and living expenses should you lose your job. Of course, these emergency savings accounts don't need to be fully funded before you start funding your goals, such as retirement, but you need to be able to handle a short-term emergency with cash. Otherwise, the first thing you will do is stop funding the goal anyway, and you may even be tempted to use the savings for that goal (with potential penalties) to cover the emergency.
Primary emergency fund
Many planners suggest a single "emergency fund", typically enough cash to cover three to six months of living expenses, but most don't address the need for multiple accounts. Having all of your savings in one account to cover all emergencies can lead to problems. First, if you only have one fund, it ends up being continually accessed for all kinds of emergencies, which means it's probably depleted and inadequate when you have a "real emergency", such as a job loss. Second, having thousands of dollars in a single account without a clearly defined purpose other than "emergencies" will provide a temptation to begin using it for other things that aren't true emergencies. After all, the money is just sitting there doing you no good, and there's a great deal on a new widescreen TV! At least you'll be buying it with cash, and you can always save a little bit more and in no time the account will be back to where it was, right? Of course, as things happen in life, just two weeks after you buy that TV, the car stops running or you lose your job!
For our purposes, the primary "emergency fund" is to cover the loss of a job. For most people, this is or should be a huge concern. How would you pay your bills and living expenses if you lost your job tomorrow? Even if you have the education and technical skills to easily find another job, it could still take a month or two to get hired and receive that first paycheck. If you are highly paid, then it could take up to six months or more to find an equivalent paying job. What if you don't lose your job, but you are in a bad accident and are out of work for even a few weeks. Even disability insurance doesn't kick in right away, and then it only pays a percentage of your income. Think for just a minute and you may realize that there are lots of ways you could find yourself without a paycheck. How would you pay your bills, and for how long could you pay your bills. For all these reasons, it is recommended that this true emergency fund have enough money in the bank to cover your bills and living expenses (not income) for three to six months, and not be used for any reason other than a job loss.
Obviously, your specific situation could suggest less or even more. If you have a career in the military or government, where you have fairly certain job security, then your concern about a job loss and the need for emergency savings might be less. Alternatively, if you are a high-priced executive, it could take a year to find a new position. Analyze your particular situation and make your own judgment, but consider it carefully, because it could mean the difference between surviving with minimal stress and losing everything you own!
One more note with regard to this emergency fund. It's expected that it will take time to fully fund this account, probably a few years. If you consider that six months of living expenses might represent 30% of your gross annual pay, one suggestion might be to try and save 6% of your income for five years.
Secondary emergency fund
Your primary emergency fund is strictly to cover expenses during a job loss, and it should never be used for any other purpose. Therefore, you need a second savings account to address irregular or unanticipated expenses, such as:
- household repairs (insurance deductible, new roof, water leak, air conditioner)
- replacement household appliances (washer, dryer, refrigerator, dishwasher, oven)
- automobile repairs (accident, insurance deductible, new tires, expensive repairs)
- excessive medical expenses (surgery, braces)
This savings account should not be used as an extension of your checking account to cover vacations, Christmas, a new car, etc. Optimally, these would be considered savings goals, and you would be saving for each of them as part of your money management plan, which also includes the savings required to fund these emergency savings accounts.
The real question for this second emergency fund is always how much to save, and this depends greatly on your specific situation, although it should not be ignored or minimized. If you have excellent medical coverage, no children, no house and a new car, then your savings needs might be as little as $2,000. Conversely, if you have poor medical coverage (high deductibles), an older house with an aging roof or air conditioning system, cars that could need repairs, then you probably need $10,000 or more in this second emergency fund. Ideally, similar to your primary emergency fund, you would build up this account over time, preferably by saving a percentage of your income in this account every payday. If you chose, say 4% for this account, then combined with the primary emergency fund, you would be saving a total of 10% of your income to cover all kinds of emergencies.