All too often than not life has a sense of irony. Or at the very least kicking you when you are already down for the count, just to make sure you're getting the full experience. As the recent economic downturn has taught us, everything fiscal is linked on an intimate level to everything else. A poor housing market will drag down the retail industry, which drags down the manufacturing industry, which raises prices on consumer goods, which feeds back to the retail industry and so forth.
As such you should be prepared for the worst case scenario. In turbulent times a relatively insignificant problem with your finances can spiral out of control, leaving you in a situation wherein you have to take on more debt than is healthy. Take the current situation for example. The folks losing their homes right now fall into two categories. Those who planned for the worst, but clearly didn't have a realistic image of a worse case scenario and those who did not (or were unable).
Regardless of which category these people fall under, it's a pretty terrible time for them. But straying away from predatory lenders aside, they had the opportunity to prepare for the crisis back when times were good. All they had to do was squirrel away some of their income.
An emergency fund is apart from any other. A vacation fund is drained every year, likely. A retirement fund is only touched (hopefully) in preparation for your golden years. A college fund is emptied during several years after high school. You don't touch an emergency fund. It remains unmolested until the worst case scenario happens.
Whether that's a death of a spouse, the loss of a job or some other disaster is immaterial. It's there for you in your time of need and not your time of want. A lot of people skirt around the issue, claiming that it's easier to live off of credit cards or small loans until everything is back on track. Which is true, in part. A credit card can stave off the power going out or the car being repossessed.
What it can also do is enslave you for a number of years if used improperly. Suddenly that $150 spent on your Visa to keep your heat on for another two weeks balloons into $300 as it becomes increasingly interest laden. Now add groceries, rent, car payments, insurance, the phone bill and the power bill. If your financial situation does not improve you're on the fast track to bankruptcy. A single month of living purely on credit can take a really long time to pay off, depending on the interest rate involved.
An emergency fund is not only always there for you (unlike credit, which may dry up due to inactivity, poor management or poor economy), but it works for you. If dwelling within a savings account at your local bank or credit union it'll earn you interest instead of the other way around. So suddenly your $1,000 worst case scenario cash becomes $1,100 and so on.
A lot of people suggest somewhere between 3 - 6 months of income packed away for an adequate emergency fund. I think this number is just about right, especially considering the most common need is due to sudden job loss. A job, especially in a poor market can take a long time to find. And even then you might need to take a cut in pay to keep food on the table.
But I like to take it a couple of steps further than that. People are fickle and emergencies come in many varieties. The car needs a costly repair, you have an accident while uninsured, your dog needs surgery because he ate a particularly unhealthy diet of sneaker and Christmas tree ornament. So in any given year there are bound to be a couple of fully justified reasons to dip into the emergency money.
I like to suggest several savings accounts that you regularly contribute to until they've reached a predetermined ceiling and all together they should equal roughly 3 - 6 months of your current income, matched if your income raises.
- Job: A savings account established in the event of your company going under, being laid off of you being fired. This should arguably be the biggest fund at your disposal due to the fact that loss of primary income shuts down the flow of money.
Also keep in mind certain factors such as your industry. If you're employed in a volatile niche such as real estate you're going to need a bigger fund because hard times will likely be longer. If you're employed in an industry that has a great demand for workers, such as nursing you can afford to redirect some of your money elsewhere.
- Car / House: While these can of course be divided if needed, they go hand in hand. This account should be roped off for the harder times involving your home and car. While insurance typically handles most things, some states don't require insurance. And some insurance plans only cover a tiny fraction of possible scenarios.
Imagine your car's muffler rusts out due to inattention. Or you find yourself driving over a couple of cases worth of broken beer bottles leaving a party. Or maybe your roof develops a pretty steady leak and needs repair (and mold mitigation.)
- Pet: The hardest thing a pet owner has to do is put down their companion because they can't afford to have a costly, live saving surgery performed. Think of how many hours of enjoyment and love your dog, cat, ferret or bird has given you over its life time. Now imagine how gut wrenching it'd have to be to put it down because your credit has dried up and you don't have the means to help it.
- Health: Hopefully you have insurance, but even if you do there are many costs involved. Co-pays, tests, studies and medication will wind up costing you a lot if they come out of left field and are unaccounted for in your weekly budget.
Using the logic that you're young and thus won't need very much medical care doesn't carry much weight. Especially if you find yourself falling on a patch of ice and breaking your ankle or getting into a car accident.
While it's impossible to save up enough to cover every medical emergency, a couple of thousand dollars will more than cover the co-pay you may have to pay if you need an emergency room visit and a barrage of x-rays.
Your fund should also remain available at a moment's notice and should not be tied to anything volatile. It shouldn't be invested in the stock market or stuck in a 6 month CD. A regular savings account is more than adequate for most people.
Not only will it be there for you when you need it most to lend you some flexibility, it'll give you peace of mind when you don't. Which is crucial, especially in dark economic times.