One of the cornerstones of good personal finances is to have some sort of backup plan available, just in case you run into unexpected financial problems. We often refer to this type of backup plan as an emergency fund or a rainy day fund.
For many of us, these are the same thing. However, it could be a smart thing to make a distinction between the different types of financial backstops.
“People organising their money should think of a rainy day fund differently than an emergency fund,” says Stephanie Genkin, an independent fee-only financial advisor who teaches personal finance classes in Brooklyn, New York.
Being able to tell the difference between these types of funds, and understanding when it’s appropriate to dip into the money you’ve saved up, can go a long way toward making sure that you aren’t wasting your money, or getting into deeper trouble.
What is an emergency fund?
“An emergency fund is what you’ll need to cover expenses if you are unemployed for a few months,” says Genkin. “It may also be used if you get sick and have unexpected medical bills.”
Your emergency fund should be for more serious events that may last weeks or months. Building up an emergency fund properly requires that you think about what would happen if you needed an alternative way to cover your expenses in the event your main source of income were impacted, or if you had a major financial catastrophe representing a drain on your resources.
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Your goal should be to build up your emergency fund so that it has around six months’ worth of expenses in it. You can build up a bigger emergency fund for better peace of mind if you wish.
Your emergency fund should be built up over time, and it should only be accessed during times of true hardship. It’s a way to plan for the unexpected big things that can drag your finances down.
How is a rainy day fund different?
“A rainy day fund, on the other hand, is something less catastrophic that you want to have money on hand to cover,” says Genkin. “It’s to deal with an unexpected, one-off event that you wouldn’t have the money for in your checking account.”
Some of the expenses that a rainy day fund can be used to cover include car repairs and replacing broken appliances. Additionally, your rainy day fund might be used for last-minute travel, such as what is needed to visit a sick relative or attend a funeral.
Rather than building up an emergency fund that can stand a drawdown that takes place over a longer period of time, the rainy day fund could be lesser, according to Genkin.
I have a similar setup to this with my own finances, even though I didn’t realise it until communicating with Genkin.
I have a highly liquid account, with what amounts to three weeks’ worth of expenses, and this serves as my rainy day fund. My emergency fund, however, is kept in a taxable investment account, where it can grow over time, and that I can access if I need to.
