When something bad and unexpected happens in your life, not having money makes the problem worse. That's an obvious statement, but few people stop to think about its implications. So when financial experts say that every person or family should have at least 6 months of expenses in an emergency fund, few people actually heed the advice.
Let's define "emergency fund." It is money that is immediately accessible for basic expenses, like rent or a mortgage, food, and utilities. It is the amount of money you need each month to basically keep going, but without life's little extras. Building a nest egg that is equal to about six months of those expenses will provide a financial cushion.
Your emergency fund money should be put in a savings or investment account from which it can be accessed immediately AND which is very, very safe. That means using a savings, checking, or money market account. It should not be a certificate of deposit (CD), individual stocks, or a mutual fund. The CD will usually have a waiting period during which you can't get access to it without a financial penalty. Stocks and mutual funds are potentially volatile, and so you can't count on your emergency fund being the size that you need when the unexpected happens. (And for anyone who argues that mutual funds are safe, the market performance during the fall of 2008 and spring of 2009 should put those assertions permanently to rest.)
The reason an emergency fund is so important is that it provides ready cash just when you are most vulnerable. It pays your rent when you lose a job. It pays for an unanticipated medical emergency. It covers your expenses if your home burns down, or is a downpayment on a car if your car falls apart. For these occurrences and many more, having money can go a long way towards "solving" the problem. At least, the money can minimize the impact of the problem and give you the luxury of making a better decision. In other words, you don't have to panic and take the first job you're offered, or put off medical treatment, or buy a lousy car because it's cheap.
The impact of not having an emergency fund is frightening. Sadly, it's what many people face today. It's suffering a home foreclosure due to job loss. It's a lingering illness for a child, due to lack of medical care and money to pay for treatment. It's living without a car. It's moving back in with parents, or sleeping in a friend's spare bedroom.
The alternatives to an emergency fund will only make a situation worse. For example, many people are putting basic living expenses on their credit cards because they don't have any savings. Then, the bill comes due, and they can only make the minimum payment. Suddenly, they are paying 20% annual interest on their loan balance, and the hole just gets deeper. Other people are selling prized items - always at a huge discount - to get some cash. People who are fortunate enough to have retirement accounts are cashing-out, thus paying financial penalties on early withdrawals and also depleting money that they will need later in their lives.
Some people are living even closer to the edge. They are turning to illegal measures to get money, or they are in such despair that they become violent towards others and towards themselves. If this sounds like an exaggeration, read the U.S. newspapers about the number of heads of households (men and women) who've killed themselves in the last year, due to distress over finances. The number is growing.
Would an emergency fund have saved the most forlorn and ragged people? Perhaps not. But it might have provided them with the breathing room they needed to return their lives to stability. And, ultimately, that's what an emergency fund is: a stabilizer for the times when life hands out unpleasant surprises.