Why an emergency fund is better than a credit card and what it should be used for

Dear Dave,

I decided it was time to take back control of my money. Your plan seems achievable, but I’ve told friends about it, and they think I’d better use a credit card in an emergency. Can you explain why you advise saving a separate emergency fund?

Leslee

Dear Leslee,

When bad and unexpected things happen, like a layoff or a burnt out car engine, you shouldn’t depend on credit cards. If you use debt to cover emergencies, you are digging a financial hole for yourself. My plan will get you out of debt forever, and a solid foundation for any financial house includes an emergency fund.

Building a fully funded emergency fund is the third step in my plan to get out of debt and take control of your money. Before reaching this point, however, steps one and two must be completed first. Baby Step 1 is saving $ 1,000 for an emergency start-up fund. Baby Step 2 is where you pay off all debt except your house using the debt snowball method.

A fully funded emergency fund should cover three to six months of expenses. You start the emergency fund with $ 1,000, but a full emergency fund can range from $ 5,000 to $ 25,000 or more. A family that can earn $ 3,000 per month may have an emergency fund of at least $ 10,000.

What is an emergency? An emergency is something you had no way of knowing was going to happen – an event that has a major and negative financial impact if you can’t cover it. Emergencies include things like paying the deductible on health, home, or auto insurance after an accident, job loss, a blown automobile transmission, or your home’s heating and air conditioning unit suddenly biting the dust.

Something on sale that you “need” is not an emergency. Repairing the boat, unless you live on it, is not an emergency. Want to buy a car, a leather sofa or go to Cancun? Not emergencies. Prom dresses and school fees aren’t emergencies either.

Never rationalize using your emergency fund for something you should be saving for. On the other hand, don’t make payments on medical bills after an accident while your emergency fund is fully loaded. If you’ve gone to the trouble of setting up an emergency fund, make sure you are absolutely clear on what constitutes and what does not constitute an emergency.

Also, keep your emergency fund in something liquid. Liquid is a monetary term which basically means easy to access without penalties. I use growth equity mutual funds for long term investing, but I would never put my emergency fund in. I suggest a penalty free money market account and full check writing privileges for your emergency fund.

Your emergency fund account is not intended to build wealth. It’s an insurance policy against rainy days!

-Dave


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