Emergency Funds: When to Use, Mini-Funds, & Better Rates

By April Dykman

Once you've started to build your emergency fund, you'll have to decide how and when to use it. What is considered an emergency? Assess a situation by need and predictability, and learn how to cover foreseeable expenses without draining your emergency fund.

Once you've started an emergency fund, you might encounter a situation where you need cash, but aren't sure if the need is an actual emergency.

When is it okay to use your emergency fund, and when should you leave it intact? Some situations are easily understood to be emergencies. If you suddenly lose your job or are unable to work, that's an emergency. But what if your car needs new tires? The tires are a need, but is it an emergency? What if your TV breaks and you can't watch your Tuesday night show? It's not a need, but it might feel important if it's your favorite program.

Some situations are harder to determine--the tire example, for instance. Others are clearly not emergencies if you step back and look at the situation--like the TV. The two biggest factors to consider when deciding when and how to use your emergency fund are need and predictability.

Defining "Need"

A need is an expense you are contractually obligated to pay or an expense for food, shelter, health, or your means of earning a living. You have to buy groceries, you have to pay the rent, and you have to pay the electric bill. If you are under contract for, say, a cell phone plan, you have to pay that, too, or else face penalty charges. If your car breaks down, you likely need to have it repaired so that you can get to work.

If your TV breaks, nothing significant will happen, which is why replacing a TV is not a need and shouldn't be a reason to pillage your emergency fund.

Defining "Predictability"

Now that you know what constitutes a need, the next question is to ask if that need is predictable. Maybe you didn't have a clue that you would be laid off at work. That would be an unpredictable event.

But needing to replace your tires isn't really unforeseeable, since you know you'll have to do it approximately every 40,000 miles. (Edmunds.com suggests getting a more accurate idea of tire life using the Uniform Tire Quality Grading tread life number.)

There are a lot of expenses like this that don't necessarily come like clockwork each month, but have to come around at some point: auto repairs, home repairs, property taxes, auto insurance paid bi-annually, irregular bills, and doctor and dentist appointments.

These irregular-but-foreseeable expenses shouldn't be drawn from your emergency fund if you can help it. Instead, consider setting up separate mini-savings accounts, each designated for a specific purpose, such as home repairs. Figure out how much money you should put into each account based on past spending. For example, if you need new tires every two years, and your tires run $1,000, you can set up an automatic deposit of about $42 per month into your tire replacement savings account. Automating your savings is the simplest way to make sure you'll have $1,000 in the bank when it's time to replace the tires.

This is not to say you can't use emergency fund money for car repairs, but if you do, you'll need to replace the emergency funds as soon as possible. If you have three months of expenses saved in your emergency fund and use some of it on car repairs and property taxes, you're putting yourself at risk should you lose your job or encounter any other true emergency. Maybe now you only have two months of living expenses, which increases the pressure of a job loss.

By keeping other savings separate from your emergency fund, you have the peace of mind of knowing the money for real, big emergencies is safely tucked away.

Where to Stash Emergency Funds

Emergency funds for unforeseeable expenses need to be readily accessible, making an FDIC-insured savings account or no-penalty CD ideal. If your mini-savings accounts have a significant amount of money, you might buy CDs and structure them into a short-term CD ladder. With a CD ladder, every so often a CD matures, freeing up some cash. If you don't need the cash, you can roll it into another CD term.

If you're thinking of building a CD ladder, be sure to compare bank rates on high interest savings accounts and CDs to determine which would offer better interest rates given the flexibility you need.

It's worthwhile to protect your emergency fund. After all, it's there as a safety net, and it serves an important purpose. Being clear on what constitutes an emergency will help make sure that it's there when you truly need it.