5 Mistakes to Avoid When Building Your Emergency Fund

by Shawanda Greene

Building an emergency fund is money management 101. You could lose your job, get pregnant unexpectedly or discover your health insurance doesn’t cover a costly medical procedure.

Like the grotesquely, entertaining Spike TV show, 1000 Ways to Die, there are, at least, a 1000 reasons you’d need to get your fingers on a hunk of cash – quick. But mostly, the emergency fund comes to the rescue whenever you suffer a drastic decrease or complete loss of income.

The ideal size of an emergency fund varies among experts. Dave Ramsey says 3 to 6 months’ of living expenses. Suze Orman says you need 8 months’ worth of living expenses while Ric Edelman recommends no less than 12.

Based on this guidance, the formula for calculating the size of your emergency fund is simple. Tally up your monthly expenses. Then, multiply the resulting amount by a minimum of 3 or a maximum of 12. So, in theory, $20K will last 8 months if you have no income, and your monthly living expenses are $2,500. Right?

Not so fast, young grasshopper. As simple as the concept of creating an emergency fund is, there are still opportunities for you to screw this up.
Black rainy day fund coin purse

Let’s count the ways.

1. Not Making Your Emergency Fund Big Enough

You may be tempted to underestimate your monthly variable expenses. Fixed expenses such as rent, insurance and student loan payments are difficult to lie about. Food, entertainment and personal care allow for a bit more magical thinking. The money you need to save shouldn’t be based on a fairy tale in which you forgo tiny luxuries.

Even in the event of a job loss, you won’t suddenly change your spending habits. If you’ve had a standing bi-weekly hair appointment for the last 7 years, include this expense in your calculation.

2. Counting on Your Emergency Fund to Cover Non-Emergency Expenses

As long as I can remember, Christmas has fallen on December 25th of every year. If you’re driving a 15 year old clunker, isn’t it reasonable to assume you’ll need another car soon?

If you can anticipate with almost absolute certainty that an event is likely to occur, it’s not an emergency. Don’t violate the spirit of an emergency fund. Set up another bank account, and save for predictable expenses separately.

3. Forgetting to Factor In Employer Paid Expenses

There’s one expense that’ll wipe out any savings that may occur from a job loss: health insurance. While you’ll likely notice a reduction in transportation costs, you’re gonna be on the hook for 100% of health insurance premiums.

According to the Kaiser Family Foundation, in 2010, average annual health insurance premiums were about $5,000 for an individual and about $14,000 for a family. That’s a lot of money to overlook.

Additionally, if your employer is paying for your gym membership, cell phone bill, and other perks, get ready to pay up for those.

4. Assuming Credit Is a Viable Substitution for An Emergency Fund

By definition, credit is someone else’s money. As a result, access to it can be taken away at any moment. Besides, do you think it’s a good idea to go into debt when you’re faced with a crisis?

5. Looking to Retirement Accounts for an Emergency Bailout

Cash out a traditional 401(k), a traditional IRA, or other tax deferred retirement account before you’re 59 1/2 years old, and you’ll likely get slapped with a 10% early withdrawal penalty in addition to any income taxes you’d owe at any age.

Even borrowing from a 401(k) can be costly. Yes. You repay the 401(k) loan to yourself, with interest. But you’ll pay double the taxes for this privilege. Once when you repay the loan with after-tax money and again when you withdraw the funds in retirement.

Lose your job before paying off the balance of a 401(k) loan and you, most likely, have only 60 days to repay the entire outstanding balance. Fail to do so, and the unpaid balance is considered a withdrawal subject to taxes and penalties.

What other issues have you overlooked when saving for an emergency fund? 

This post was mentioned in the Carnival of Personal Finance #320 – Plutus Awards Edition at Canadian Finance Blog.

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{ 11 comments… read them below or add one }

Green Eyed Bandit July 18, 2011 at 8:18 PM

I love it. This is a great post for my financial group to discuss. Several of us are still in the emergency fund stage.


Shawanda July 18, 2011 at 11:00 PM

Thanks! I hope your financial group finds the information helpful.


@boomerang24 July 20, 2011 at 12:55 PM

You make an outstanding point on number 3. This certainly is an expense that gets overlooked and can make a big impact on how far your emergency fund goes.

On the other hand, I agree with number 2 only because some people are stupid. If I lose my job, ALL extras stop. I cut cable, I stop eating out, I might cancel garbage service and find a dumpster. I can restart all that stuff once I GET A JOB. That said, it's good advice for people who tend to ignore the reality of a situation.

My last comment is on #1. Something to keep in mind when considering Dave Ramsey's advice about 3-6 months of expenses is that (if you're working his system) the person is DEBT FREE. They have significantly less risk in their lives and so 3-6 months is reasonable. If you can't find a job in 3-6 months, you might want to check out Dan Miller's book "48 Days to the Work you Love." Notice 48 days is less than 6 months [wink].


Shawanda July 20, 2011 at 1:17 PM

Good point on the 3 to 6 month emergency fund recommended by Dave Ramsey. I believe Suze Orman teaches to save the emergency fund first before paying off credit cards. Ric Edelman is a strong proponent of big, 30-year mortgages. So, under Suze and Ric's recommendation, there's a chance you're making larger debt payments if you're unemployed. If I had to choose, I'd combine Dave's debt free strategy with Ric Edelman's 12-month cash reserve strategy.

On Dan Miller, I just started listening to his book No More Mondays again. This will be my 3rd time listening to the audiobook. I've also read it. I don't know if you've read Quitter by Jon Acuff, but I highly recommend that one too.


@boomerang24 July 20, 2011 at 8:39 PM

I have not, but it's in my "wish list" on Amazon. I've got a few ahead of it in the que. Thanks for your posts. Always a good read.


Danielle May 31, 2012 at 4:51 PM

I think nine months is a great goal! Three to six months is sufficient in a better economy, but with today's situation in mind, anywhere from at least 6-12 months is a safer choice. For more information on emergency savings, check out http://www.clearpointcreditcounselingsolutions.or….


MD May 11, 2014 at 11:12 PM

A hair appointment in an emergency? I find it absurd to think anyone couldn’t scale back on a few things in an emergency, then again I’m a guy.


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