Having an emergency fund is one of the keys to financial satisfaction. Many pundits will say that you need to have three to six months’ worth of living expenses (debt service, rent or house payment, groceries, insurance, etc.) in a cash savings account to be financially secure. They make a point. It would be nice to have enough cash on hand to see you through a change in jobs, but that might seem like a luxury right now. It is especially luxurious if you are just starting out or among the financially challenged at this point in the economic cycle.
Having a six month cushion would be nice, but do you need that much? If the bulk of your income comes in the form of a steady salary, three months is sufficient for most households. If part of your pay comes from commissions, or if you are uncertain about the security of your job, a larger emergency fund is appropriate. However, your first savings goal should be to put $1,000 into a savings account and keep it separate from your other accounts. I call it the Karma $1,000.
When your finances are tight, there is nothing worse than finding out that you have to spend $300 at the dentist or $400 to get a belt replaced on your car. These are the kinds of expenses that are not budgeted and could cause you to charge up your credit card, borrow from a family member, or do something else that is financially or personally risky. If you have $1,000 in the bank waiting for just this situation, a trip to the emergency room for a few stitches doesn’t have to ruin your month, or your vacation plans.
Here’s another thing about the Karma $1,000 – when you have a little money in the bank, you are less likely to need it. I don’t have specific research to back this up, just many years of observations. There is a known relationship between financial stress and job performance. I think that extends into our personal lives. Having $1,000 in a savings account has the effect of diminishing stress in our lives, making us less likely to back over a curb, or bite down wrong on a piece of toffee. That’s where the Karma comes in; money in the bank, even that little bit, makes you less accident prone.
Other thoughts: if you have to tap your Karma $1,000, be sure to replenish it right away, even if you can only add $10 or $20 per week. Next, more savings equals more Karma! As this Wall Street Journal article states, $2,000 is the cost of a major auto repair, so make that your next goal. Once you are there, focus on adding a little bit more each pay period until you reach that three month goal.
Also, this is an emergency fund, not an investment account. Savings accounts earn virtually nothing in interest. Most money market funds pay a teensy bit more and are still very accessible. Talk to your bank or credit union and ask what is available. When you’ve got three months worth of emergency savings, we can take the next step and talk about laddering some CDs, but not yet.
In conclusion, it sure would be nice to have a big fat cash cushion to see you through any potential life transition, and it is an important goal to achieve. However, if you are just getting started on your road to financial independence or experiencing hard times, start with an emergency fund of $1,000 to keep Karma on your side. Keep it funded and build it up to $2,000, then set three months worth of living expenses as your next goal.