An emergency fund is some money you have set aside, or otherwise earmarked, to be spent in a time of financial emergency. This could be a bill that would be unaffordable when taking into account your disposable income.
Why do I need an emergency fund?
The idea of an emergency fund is to cover need, not to fund unnecessary expenses or act as savings. To give an example, an emergency fund is would not be used to save up for a new car. Instead it would be used if you were suddenly hit with a large repair bill and doing without your car would not be possible, for example if you can't get to work by public transport.
Most people use an emergency fund to protect against one-off expenses, though some people also use it as protection against a temporary loss of income, for example through illness or unemployment. Before using an emergency fund in this way, consider whether relevant insurance might be a better idea, though do check terms and conditions carefully.
How big should an emergency fund be?
This is a very debatable subject. Most financial experts suggest the equivalent of three to six months worth of income, though it may be more sensible to use your spending levels over such a period instead. It's important to realize that it will take quite a while to build up such a fund, so don't be discouraged if it seems unobtainable.
To start with at least an emergency fund should be as big as you can reasonably afford without cutting back on essentials. You could begin by setting aside a manageable amount each week or month, possible via an automatic deduction from your account. Treat the fund as a mandatory expense such as rent or utility bill payments.
Should I put all of my money into an emergency fund?
No, and in some cases this can be counterproductive. For example, you shouldn't skimp on necessary spending now in order to build up your emergency fund. This includes money you spend on insurance: $100 paid as a premium is likely to be far more useful than $100 set aside for future spending, especially if your insured event could be costly.
What characteristics make for a successful emergency fund?
Generally you'll be looking for an option that lets you build-up interest, but also lets you access the funds quickly if needed. This rules out savings plans with lengthy notice periods. It also means stocks and similar investments are a bad idea as there's no guarantee you'll be able to get the cash back quickly without taking a big hit if markets have gone against you.
For many people the best option is a separate savings account that you won't habitually raid for ordinary spending, but can access easily when needed.
Does an emergency fund have to be separate?
In principle, no. The main reason for a separate fund is partly administrative, to help you keep track, and partly psychological to help you avoid the temptation to spend it on non-essentials. If you are very disciplined, you can achieve the same effect by earmarking part of your current finances as emergency funding. For example, if you have a $2,000 overdraft facility, you can create a virtual emergency fund of $1,500 by making sure you never go more than $500 overdrawn. This may require great determination and organization however, so it isn't for everyone.