You have probably heard the term “saving for a rainy day,” but what does this mean? Perhaps your company announce they are closing down, making people redundant or it could be a personal issue like the sudden death of a relative and a funeral to pay for or something less tragic like the boiler breaking or the roof caving in.
A rainy day fund is an account with money available to pay for unexpected life events that will take you by surprise. It’s recommended to have at least one month of your pay available in an account to deal with any unforeseen circumstances before you look at resolving other money issues or working towards other financial goals. Six to nine months of salary would be better especially if you are self-employed, but this may take a while to save. Aim for a month first and then increase this amount as and when you can.
A poll by Bankrate Money Pulse found that less than 40% of respondents had enough money put aside to cover minor incidents like a car repair. It’s hoped that once you have your emergency fund in place that it will go untouched until it’s needed.
If something does happen, what should you do with your emergency fund? It depends on the incident, the amount of money you have managed to save and the length of time you will need to use your funds.
Let’s take a look at three scenarios where emergency funds might be used and the best way to manage each situation.
Emergency Fund Situations
If you have saved a total of $2000 into an emergency fund over two years and then suddenly your car breaks and needs extensive repairs totaling $2500. You could pay for it by using your emergency fund and taking the rest from your checking account and cutting back on non-essentials for a month.
You consider taking a credit card instead to pay for the repairs and then paying the balance off over several month.
What should you do?
In this situation if would be better to avoid using a credit card as if it took two years to save $2000 it will be hard to pay off a credit card with an interest rate of 10% APR which could amount to hundreds of dollars in interest.
The best thing to do in this situation is to use the emergency fund and pay the rest from the checking account. By cutting back on non-essentials and saving around 8% of your income you can save up the same amount in about a year if you’re earning around $40,000 a year.
It may also be an option to purchase a used car by trading in the old one and spending the $2500 on this alternative solution rather than on very costly repairs to fix the old car.
You and your partner have managed to save a $20,000 emergency fund, by saving $1000 a month, and then one night a tree falls through the garage roof and damages the side of your house. The tree was on your property and you didn’t realize it was rotting and take care of it so your home insurance won’t fund the repairs. As well as fixing the garage and removing the tree the wall of the house also needs to be repaired and the lowest estimate is $18,000.
Your emergency fund would be able to pay for the total costs but would remove that sizeable buffer you have built up. You could cut back on non-essentials for a few months saving around $1500 a month but it would then take you up to a year to save up to pay for the repairs which is impractical and it would be hard to be so restrictive for so long.
What should you do?
In this situation, with your record of being able to save money you may want to keep some of your emergency fund and apply for a home loan. This is not usually a preferable solution but you will be able to get the repairs done quickly and then pay back the credit fast too.
If you use the $1000 plus the $1500 you could contribute by cutting back on non-essentials you could probably pay off the loan within seven to eight months. This would also allow you to keep your emergency fund.
Another option would be to pay for some of the repairs from the emergency fund and then fund the rest with a loan which would reduce the amount you need to pay back each month and build your emergency fund back up again and reduce the need to be so restrictive. If you choose to do this try to lend what you can pay back in less than two years or you may end up paying back a lot of interest.
You and your partner have an emergency fund of around $30,000. One day your company announces that they are downsizing and you’re going to lose your job. As you haven’t been at the company long your payout will be minimal.
Your income pays all the bills and your partner’s money pays for all the fun family outings as well as children’s school fees, music lessons and sporting activities. Your income is now reduced to almost half and you consider seeing how long you can go without using your emergency fund but aren’t sure how long it will be before you can get another job.
[Read: 14 Signs you’re headed For Big Trouble with Debt]
What should you do?
As your job will affect your ability to pay for bills and essentials it would make sense to use your rainy day fund. You also need to look for another job that pays similarly to the last job you had. You may need to restrict non-essentials for a while, think about changes you can make to your lifestyle and reduce some of the children’s additional activities for a short time.
With so much in the emergency fund it’s not likely that you will be in trouble in the short term but you need to make sure you seriously consider long term solutions.
So, what’s the cost of having no emergency fund: