Why Do You Need an Emergency Fund?

"I'm putting every spare penny into my retirement fund," a young colleague once told me. "I have a home equity loan and high limits on all my credit cards. Why do I need an emergency fund? The interest on a savings account is less than one percent."

There's nothing wrong with saving aggressively for retirement, and having good credit is important. But one major accident, natural disaster, or health crisis can wipe out a family's prosperity. Everyone should also have an emergency fund: three to six months' living expenses socked away in a low-risk, liquid investment, like a savings account or money market fund.

If you suddenly lose your job or are hit with an unexpected large bill, you don't want to have to tap that retirement account. Not only will you lose the time value of your investments, but you may have to pay a 10% tax penalty if you don't meet the age or other criteria for making withdrawals.

Credit cards are great for large purchases—if you can pay them off in full when the bill comes, or at least as quickly as possible. Otherwise, you'll be saddled with a high rate of interest and that large expense will cost you even more. And a home equity loan? Your interest rate will probably be lower than with a credit card, but don't forget: the loan is secured by your home. If the emergency is unemployment, and it takes you months and months to find another job, you could find yourself deep in debt and in danger of losing the roof over your head.

Investment products like stocks, bonds, and mutual funds are good for building wealth, but you want to be able to choose when to sell. If you're forced to liquidate one of these investments to meet an emergency expense, you may lock in losses in a down market, or face a higher tax bill due to capital gains on appreciated assets.

A savings account or a money market fund may seem like a boring investment, but the money will be there, intact, tax-free, in case of an emergency. And you should only touch it if there is an emergency.

And what constitutes an emergency? A vacation is not an emergency. Perhaps an unforeseen trip for a funeral could be considered such.

A new car is not an emergency, unless your old one was totaled in an accident or had a complete breakdown before its time.

Redecorating the house? No. Rendering your house habitable again after a disaster? Certainly.

Large expenditures such as weddings, births, graduation bashes, cruises, college tuition, landscaping, major appliance or vehicle purchases are important, but they should be planned and funded with dedicated savings. An emergency fund is reserved for expenses that arise unexpectedly. And when that happens, you'll be glad it is there.

What are your thoughts about emergency funds? I would love to hear your comments.

Sharon Marchisello is the author of Live Cheaply, Be Happy, Grow Wealthy