Why You Need Both a 'Rainy Day' and an Emergency Fund

Purpose and Duration of These Funds

The purpose of a rainy day fund is to protect you against unforeseen one-time events, and give you the cash to deal with them without upsetting your monthly budget.

Assume, for example, that you had $1,000 squirreled away in a rainy day fund. That money could cover you in the event your car broke down or your washing machine needed to be replaced. Such scenarios would be a pain to deal with, and economically unpleasant. But these challenges are nonetheless short-term in nature. 

By contrast, an emergency fund needs to have enough money to pay your living expenses over a period of three to six months. A healthy emergency fund will tide you over in the event of a major, long-term disruption in your life, such as divorce, job loss, medical illness or injury.

So think for a moment about your normal bills: Are they $2,000 a month, $4,000, far less or far more than these figures?

Whatever your expenses, multiply them times three. Then you'll know how much cash you need for an emergency fund that would last three months. Multiply your monthly bills by six to calculate how much money you'd need for a more prudent six-month emergency fund.

Benefits of Added Savings

Your rainy day fund can help you avoid going into debt or using credit cards excessively to pay for unplanned, short-term expenses. It can also help you avoid resorting to more expensive forms of credit, such as payday loans, that charge ridiculously high interest rates.

Additionally, a rainy day fund affords you the opportunity to practice good fiscal habits — such as delayed gratification and self-restraint — because you must use it only for true emergencies. You won't be able to maintain it if you're constantly engaging in impulse spending or satisfying your wants as opposed to your needs.

Your emergency fund also offers those benefits, plus two additional perks: peace of mind and personal freedom.

Next: How to build up an emergency fund. >>