When that silver lining appears tarnished
Estimated Calculation Time: 30 minutes
Materials: Results from Creating a Budget, Personal Balance Sheet and Insurance documents
Project Difficulty: It depends

I was talking to a good friend of mine about personal finance and he admitted that his credit card was his emergency fund. Now, this friend is a very intelligent and insightful guy and after I picked my jaw off the floor I explained why his arrangement is a bad idea.

First, any spending on a credit card that can’t immediately be paid off will start to accrue interest. If you only pay the minimum balance, compounding interest means you are not only paying interest on what you spend, but also on the interest that you didn’t pay from previous months! Compounding interest should be working for you through savings and investments, not against you with bad debt like a credit card. Also, there are certain things you usually can’t pay with a credit card, like rent or a car payment. If you take out a cash advance to pay for these things, not only will you owe interest, it begins immediately (instead of waiting until the end of your billing cycle) and you are usually charged a fee.

So once you have decided that an emergency fund is a good idea you need to calculate the amount you need to save. Take the results of Creating a Budget, specifically the expenses that are absolutely necessary such as the electricity bill and your monthly mortgage/rent. Depending on how secure you feel about your job/income situation you should have enough to cover 3-12 months of the absolute necessities. In the current economy there are many people that have now been looking for a job for over 2 years so remember to overestimate your needs rather than underestimate. I’ve noticed that some say they can’t move to find a better job because they can’t afford it; you never want to find yourself in that position!

Now you need to add other emergency needs to your base number. Think about it, if you lose your job and 3 months later you have a car accident or you get sick and need to go to the doctor, what happens then? Although your insurance premiums should already be accounted for in your budget numbers, you need to consider your medical insurance deductible, home insurance or renters insurance deductible, and auto insurance deductible. You probably don’t need 100% of everything but you should consider each individually. A good rule of thumb is to add close to 100% of the single largest deductible (home, medical or auto) to your emergency fund goal.

Also, you should add something to your emergency fund for emergency repairs to your house, appliances and car (especially if you need it for work). Remember, even if you don’t lose your job you don’t want to go into debt just because you don’t have the cash for new tires. If you use credit instead of your emergency fund, those tires are going to cost more in the long run.

So here is a good example of an emergency fund goal calculation:
$7,500 – 3 months necessary expenses
$500 – For insurance deductibles
$1,500 – Auto/home repair
$9,500 is the total Emergency Fund goal

Take a look at your personal balance sheet.  If you don’t already have your goal in a savings account or money market fund, don’t panic but make it a priority. Figure out how building this fund will fit in your monthly and annual budget, even if it will take a few years it will be better than nothing. Finally, resist the temptation to use this for anything other than emergency needs. By the way, the following do not constitute emergency needs: a new plasma TV, vacations, Christmas gifts, the latest cellphone, a new car, and the list goes on. You need to save for these things separately from your emergency fund! I personally have a separate "high-interest" (it's not that high at the moment) account that only has my emergency fund money. Every time you think about touching the money for a non-emergency, remind yourself of the reasons and benefits for having one - and use the opportunity to be grateful that you currently do not have an emergency.  If and when you ever have to tap the account for a true emergency, don’t forget to thank your past-self for the wisdom and generosity to your present-self.