According to a recent report by the Federal Reserve Board, about half of all Americans wouldn't be able to cover a $400 emergency expense without borrowing the money or selling something they own.
While the savings rate in the U.S. has certainly improved since the financial crisis, it appears that far too few people are keeping any significant amount of savings in a readily accessible place like a savings account.
Emergency expenses do happen pretty often. While it can be unavoidable to have to borrow to pay for some large unforeseen expenses (like big medical bills), you don't want to be in the position to rack up lots of credit card debt every time you have a flat tire or need to go to an urgent care clinic.
What constitutes an "emergency expense," and how much should you have set aside for it?
The statistics are alarming
More than 4,000 American adults were asked how they would pay for a $400 emergency expense, and less than 39% said they would have the money in either a checking or savings account or in cash. Nearly 45% said they would need to put the expense on a credit card, either to pay off at the next statement or over time, and about 20% said they would either borrow the money or have to sell something (respondents could select more than one choice).
However, the most disturbing response was the nearly 19% of respondents who said they would not be able to cover the expense whatsoever. No credit cards, borrowing ability, or anything that could be sold quickly.
About 43% said they would be unlikely to be able to cover an emergency medical expense with their savings.
"Emergency" expenses happen all the time
A lot of people hear the term "emergency" and assume that it refers to something that doesn't occur very often. However, in a financial sense, it simply refers to an expense that doesn't occur regularly, and that you weren't planning for.
For example, you could get a toothache and find out you need $500 in dental work. Or, you could blow out a tire while you're driving, in which case you'll be lucky to get off the hook for just the cost of a replacement tire. Or, maybe you'll accidentally leave a pen in your pocket while drying your clothes and will need to replace most of your ruined wardrobe. Seriously, how many of us have done that last one at some point?
The point here is that none of these things are actual emergencies. If your pen bursts in the dryer, you probably won't actually dial 911. But, these are expenses that no one wakes up in the morning and anticipates.
There are literally thousands of these types of situations that could arise during any given day, so you need to be ready.
Before you start investing, you need some cash set aside
A common mistake that even responsible savers make is putting all of their extra money in investment accounts, CDs, or other long-term savings vehicles where they can't readily access their money without a ton of inconvenience.
While this is definitely a good idea for the most part, before you start saving, you need to make sure you have the cash to pay a reasonable amount of expenses that may come up.
Sure, you can always sell some investments, withdraw a CD account early, or tap into your retirement savings in a pinch, but these can all be costly. For example, to withdraw from a traditional IRA before you reach 59 and a half years of age will cost you a 10% "early withdrawal" tax. And withdrawing from a CD before it matures can easily cost you hundreds of dollars in fees, not to mention the interest you lose out on by cashing out early.
So, how much should your "emergency fund" have?
Basically, a good rule of thumb is to have at least three months of your living expenses stashed away in a readily accessible place, like a savings account. Many experts say six months, or even a year, but three months is a good start and should cover most emergency expenses.
However, many people don't realize just how much three months' worth of expenses is. To figure out yours, add up all of your housing expenses including rent or mortgage, utilities, TV, Internet, and other recurring home expenses like an HOA fee. Then add your transportation costs such as car payment, gas, and insurance.
Then remember to account for at least the minimum payments on your credit cards, student loans, and other bills. And, don't forget that you still have to eat, so your emergency fund should also account for three months of groceries. For a more complete emergency fund discussion, check out this article I wrote.
While it's ideal to have an emergency fund that will last you for months, something is better than nothing. Take it one day at a time, and once you have $400 set aside, take comfort in knowing that you're in the top 39% of American adults in terms of emergency savings. Then, keep setting aside a little more at a time and you'll have a nice cushion before you know it.
Try any of our Foolish newsletter services free for 30 days. We Fools may not all hold the same opinions, but we all believe that considering a diverse range of insights makes us better investors. The Motley Fool has a disclosure policy.