Break Glass In Case Of Fire: Keeping Two Emergency Funds
Most personal finance advisers suggest that we should have an emergency fund for those tough times. Dave Ramsey even includes this recommendation in his Baby Steps system for getting out of debt and becoming financially free.
One of the first things he tells you to do is to build a $1,000 emergency fund which you can keep in an interest-bearing account, perhaps in something like a SmartyPig savings account. You can use this baby emergency fund to hedge yourself from possible mishaps. Only after you complete this step does he suggest that you start to chip away at your long-standing debt.
This is very sensible advice, as it is important to have a safety net, even as you hack away at your old debts. One of the biggest challenges in the journey to financial freedom is losing control of the financial flow because you didn’t prepare for the tough times. Tough times are always sure to come, and merely hoping that you’ll have “great luck” for a whole stretch of time won’t cut it. You need to be prepared, and you should be watchful of your investment portfolio, especially if you’re the type who invests aggressively.
Investors Without Emergency Funds
Speaking of investors, there are many of them who neglect to create an emergency fund. They jump right ahead and pay their low cost brokerage a visit, and get right to trading stocks. They don’t bother with creating a cash cushion, and they take quite a lot of risks. Some may even still have debts!
But here’s something to note: Dave Ramsey experienced a similar type of situation when he was 26: he had aggressively invested in real estate, but had a truckload of short-term debt. The short-term debt soon became his downfall, so he changed his financial ways soon after. He climbed out of his debt hole and subsequently, he lived to tell his story and teach others how to avoid the personal financial fall he took.
Dave Ramsey has since recommended starting off with building a $1,000 emergency fund as a priority. You can do this while working on reducing your debt. After your debt has been nuked, then it’s time to start saving up 5 to 6 months’ worth of your monthly salary (I’ll call it the “living expenses” emergency fund) to avert major pitfalls like losing your job or other similar disasters.
Do Two Emergency Funds Make Sense?
Although Dave doesn’t specify whether to keep your $1,000 emergency fund separate from your “living expenses” emergency fund or to combine them in one account, it may be sensible to have them as two separate funds.
Well, the bigger “living expenses” emergency fund should never, ever be touched. This is your emergency fund which you should touch only when absolutely needed (such as during times of protracted unemployment or divorce), and which you replenish as soon as possible. As for the smaller emergency fund, it would be great to use for those immediate needs like a car breaking down, an unexpected minor health emergency, or even a computer that needs replacing.
Now some may argue that a credit card can be another source of emergency cash. Maybe you have good credit standing and you could pick up a new credit card anytime if necessary. Maybe you have all your cards in good standing and ready for you to lean on when the tough times come. However, it doesn’t change the fact that credit is still credit, and it’s just a few notches away from debt if you don’t watch it, or if your circumstances end up keeping you in dire straits for an extended period of time. Frankly, I prefer to avoid taking any more debt in this situation as it’s a lot cheaper to have your own cash account rather than rely on your card.
A shaky economy should not shake you. One of the wiser things you can do is to minimize your financial stress by ensuring that when something unexpected happens, you have something to fall back on. Like two emergency funds.
The Digerati Life is a personal finance blog dedicated to credit card reviews, high interest accounts, investment, debt management and other personal finance topics.