Financial emergencies come in all shapes and sizes. They are, by definition, obligations that you haven’t planned for and that will be difficult to pay. Whether you should have anticipated an expense is irrelevant once you’re faced with it. If you must pay it soon, and if not paying it will bring serious consequences, then you have a financial emergency.
Many people have an emergency fund — money set aside for no other purpose than to bail them out of a crisis when they have no other cash available. Even if you don’t have such a fund, there may still be ways for you to make room in your budget to accommodate the urgent expense. And if you do have an emergency fund, you can use those same methods to put off having to dip into it, which will make your “rainy day” money last longer — or preserve it for the next unforeseen expense.
Reducing regular expenses
Your first line of defense in a financial emergency should simply be changing the way you spend money. In other words, tighten the belt. Delay, reduce, or do without certain things so more income can be used to meet the emergency. With smaller unexpected expenses, you may take this first step instinctively and not even think of it as an emergency. Perhaps you get a costly parking ticket and, because of it, decide to skip taking your family to the movies. You rent from Redbox instead and pay a few dollars instead of $50 or more.
Redirecting cash saved for irregular expenses
“Flexing” your spending to deal with an emergency between paydays only goes so far. You may need to reduce spending over several pay periods to cover the emergency — but you still you need the money now. Before taking it from a designated emergency fund, look to your next line of defense: savings earmarked for an annual or irregular expense, such as a vacation, home or vehicle maintenance, or a bill that gets paid once a year.
Setting aside cash for these irregular expenses is part of any solid budget. Of course, if you tap such funds in an emergency, you’ll need to pay yourself back before these bills come around. Do that by continuing to flex your spending over multiple pay periods until the reserves are restored.
What happens when you fully flex your spending and drain your cash reserves? Will you have to sell off belongings, liquidate investments or compound the problem by borrowing money? You can avoid pawnshops and payday lenders if you have an emergency fund on top of your earmarked cash reserves. Selling stuff is usually the last line of defense.
The role of the emergency fund
An emergency fund serves as a buffer between your ability to deal with unplanned financial obligations by flexing your spending and having to take drastic measures like selling off assets.
An emergency fund is really just another kind of cash reserve. It needs to be big enough to buy you time and flexibility to reduce or eliminate some regular expenses, or, if you need to sell stuff, to figure out how to go about it. This is the root of the common advice to have enough money in your emergency fund to cover three to six months’ worth of expenses. Emergencies may last longer, but with time to plan and adjust, so can the cash.
Keep in mind that another emergency can always strike. So once you get past a crisis, you still have to keep your spending plan flexed until you replenish your emergency fund.
Bigger isn’t necessarily better
The size of your emergency fund matters — but not the way you might think. Pegging the size of an emergency fund to your current monthly expenses has more to do with the idea that people who spend more money also tend to have more expensive emergencies and less to do with how long the money will last in an emergency. Even one month’s worth of spending can offer a lot of protection, and it’s the amount I usually recommend for people who are paying off non-mortgage debt. I would rather see their extra money go toward paying off that debt than building a bigger emergency fund, although they still need some buffer for emergencies. Three months’ worth of spending is a good-size emergency fund if the only debt is for a mortgage, and six months’ worth is about as big as I go for people with zero debt.
It’s tempting to have an even larger fund — enough to cover, say, nine months’ or even a year’s worth of spending. Bigger emergency funds do offer more protection, but it’s not a dollar-for-dollar proposition because you’re more likely to need a relatively small amount of cash in an emergency than a lot. Reserving cash for emergencies is a form of self-insurance, and it should cost less to insure against things that are less likely to occur. At some point, increasing the size of the emergency fund is no longer providing the best bang for your buck, especially if you could otherwise be paying off debt.
Debt is no solution
Finally, you may ask: Why not use credit as a buffer? The answer is that borrowing does not fix the emergency. It actually makes it worse. If you have already fully flexed your spending, tightened the belt as much as you can and drained your other reserves, adding another mandatory payment will compound the problem. Rather than act as a line of defense, debt weakens your other defenses. At some point you are already out of money. How will you repay the money you borrowed?