If you want to break the chains of debt dependency, and you probably wouldn't be reading this if you didn't, I firmly believe you have to have an Emergency Fund as a cornerstone to a good debt reduction plan. Dave Ramsey and I firmly agree on this. If you don't, you have a high percentage chance of being in a worse situation then you are now.
What is is For?
Your Emergency Fund is to stop Ninja Bills. Those bills that pop up with no notice. "My muffler fell off;" Water Heater Popped:" I broke my foot by stubbing my toe" (which I did this Summer!). What is isn't for: "That is a great Driver and it's on sale, and hey I have money in savings. It might be sold-out later, It is an Emergency!!!"
I don't need one I have a credit card!
I have heard all of the arguments; "Credit Card Interest is 15-20% and I get 1% on my saving, I am better off with charging it!" You are not wrong! But if you have debt; one, you may not have enough credit and; two, all the hard work of paying it off is gone! In addition most that have money issues (which is most Americans!) have an issue clearly separating OK charges from "Stuffitis."
I hope this person doesn't mind but a favorite Blog of mine, "We Need to Be Debt Free" is a great example of what can happen when you don't have a fund. JW works really hard, starts to pay down his debt then some random act of un-mercy hits him. Back up go the charges and start over and over. It is mentally draining to continue to fall back into debt. JW is now taking those steps to establish his fund.
OK, That scared me I am in, but how much? And where do I keep it?
These are the two questions that confuse Ramsey fans the most because he picks an arbitrary number out of the air, $1000. But if you are driving an older car, own a bit older house, have kids, this many be low. For others it may be high.
As long as your major life points haven't changed recently (new kid, house, etc.) here is what we did. We went through our last 2 year worth of purchase in Microsoft Money. We identified the "emergencies" and then took the most expensive one an rounded up a bit. Ours was a $1800 repair bill on the car we still have now so we used $2,000 as our number. Important part is that it can handle most day-to-day issues that could reasonably come up. Your are right, if Killer Bees attack your monkey, you may need more, but the odds are pretty low. We WANT you to get back to paying off debt. We are only putting in a First Aide kit, not a hospital!
On the where to keep it, I feel this isn't an investment fund, so I don't suggest buying something illiquid with it like a CD or Real Estate. Put it into an Interest bearing savings account, preferably attached to you checking account as potential overdraft protection...Never Hurts.
OK, Got it...Is it OK to Use it?
I have read of people that won't touch the fund at all. It is there to be used...IF needed (see above). Our house rule is that we expend our "fun" money first. Goodbye Entertainment and Dining. Funny...that is usually enough to downgrade the Emergency to, "maybe next week".
That's it. Then move on to Step two, killing your debt. A Good Emergency Fund is the best friend of a debt reduction plan, and a very important step in breaking the chains of debt.