If you’ve ever had to pull out a credit card to deal with a dentist or emergency vet bill, you likely know the pain of wondering how you’ll pay for an unexpected expense. Or maybe you unexpectedly lost your job and finding a new one is taking longer than expected. Having an emergency fund can significantly reduce your money worries.
Emergency funds are straightforward, but knowing a few tricks can help you maximize your savings and ensure every penny is there when you need it.
What is an emergency fund?
An emergency fund is a safety net of money for unexpected expenses. It is generally kept in an account that is easier to access than traditional investments like stocks or bonds but is more challenging to get to than your everyday checking or savings account.
An emergency fund can help you get out of an immediate financial situation, like an unexpected car repair or medical bill, or can help you cover your day-to-day expenses if you’re laid off, ill, or injured and unable to work.
Because you’ve thought ahead and set aside money for a rainy day, you’re less likely to use a high-interest credit card, take cash out of your retirement accounts or try to access the equity you may have built up in your home.
How much should an emergency fund be?
How much you save in your emergency fund depends on your situation. If you have dependents, heavy debt or access to other funds, like a partner’s salary or unemployment insurance, the amount you need to save will vary.
Most experts recommend an emergency fund should be enough to cover three to six months of expenses. However, building that amount from zero can feel overwhelming.
To help you get started, focus on saving six weeks of your monthly costs to help you cover most minor emergencies. While you may not be able to cover everything with six weeks of expenses, it will give you some breathing room to make mindful decisions.
Once you have six weeks of savings, take some time to consider if that amount feels like ‘enough’ or if you’d have greater peace of mind contributing more. While it’s not easy to put other savings goals on hold as you build up this emergency cushion, it can be a lifesaver if you’re out of work without access to additional funds.
How do you build an emergency fund?
Remember that saving a considerable amount doesn’t happen all at once or in a straight line. Instead of getting discouraged, try breaking the bigger goal into smaller pieces to make the process more manageable.
Start slowly. Aim to save a paycheck’s worth of cash in your emergency fund as an initial goal. This may take months, depending on how much room you have in your budget. Remember to focus on the long-term benefits and contribute what you can, even if it’s only $20 a month.
Calculate expenses to decide how much your emergency fund should be
To begin, determine how much you need to save. Consider the minimum amount you spend each month on non-negotiable expenses like:
- Insurance (health, car, etc.)
- Prescription drugs
- Debt repayment
- Child care (if applicable)
- Anything else that qualifies as a necessity when you’re cutting spending as much as possible
Since we’re talking about necessary expenses only, you don’t need to include entertainment, dining out or savings goals like a downpayment on a house, car or a vacation fund. While you should still save for those goals under normal circumstances, in an extreme emergency, you’d likely either need to stop contributing to those funds or use some of what you have saved to cover expenses.
Once you know how much money should be in your emergency fund, develop a plan to make it happen. Break the total you’re aiming for into a monthly savings target and set up automatic withdrawals on payday to help you contribute without thinking about it.
Where should I keep my emergency fund?
When deciding where to keep your cash cushion, think about what kind of access you need to your money. Three things to keep in mind when deciding are:
Is the account federally protected?
It can be tempting to put your emergency fund into the stock market to earn as much as possible. Do not do this. While the stock market can give you higher returns, it can also bring you a higher chance of loss.
Instead, keep your funds in a bank or money market account (not a money market fund, which is a type of investment) that is FDIC-insured or in a credit union that is NCUA-insured. The FDIC or NCUA designation means your funds are federally protected by up to $250,000 per depositor.
Is the account accessible?
While you want your funds accessible, you don’t want them to be too easy to get to. Otherwise concert tickets, electronics and spontaneous travel may drain away your hard-earned progress. Keep your emergency fund at a bank separate from your regular checking and savings. It can help you avoid impulse purchases while still keeping your money available.
It’s best to keep your emergency cash in a bank rather than relying on collectibles or real estate to double as your emergency fund. If alternative investments interest you, they can certainly be in your portfolio but should not be considered emergency funds.
Should you use a high-yield savings account?
Although you want your emergency fund safe and readily available, you also want to get the best interest rate. Look for a high-yield savings account to stash your funds so you earn as much as possible.
You may find the best interest rates at an online bank since they tend to offer higher rates than traditional brick-and-mortar banks. Be sure to do your research to confirm the bank is FDIC-insured, that you understand any fees or minimum balance requirements, and that it can be connected to your primary checking account for easy transfers.
Should I save or invest?
In a perfect world, you’d have enough room in your budget to save and invest simultaneously. Since that’s not always the case, you may have to decide on your priorities.
For some, saving for retirement is their primary goal, and they have other means to support themselves through short-term money crunches or don’t mind putting an unexpected expense on a credit card.
Others prefer to avoid debt at all costs and may feel like contributing to an employer-sponsored 401(k) is enough until they fully fund their emergency savings. After all, once you’ve hit your emergency savings goal, you can direct that money toward other uses, like investing and saving for retirement.
You can even develop a hybrid model, splitting the money you earmark for saving toward both goals. It may take you longer to reach each achievement, but you’re making incremental progress with both.
There is no right answer, just the answer that is right for you. The most important thing is to develop a plan that works for you and your life. Don’t wait to start saving or investing for some far-off point in the future; start taking small steps now.
An emergency fund can help you build financial resilience and avoid going into new debt or adding to your existing debt.
Think about how much in the bank would make you feel safe and work to build your savings toward that amount. You may have to go slowly with just a few extra dollars a month but focus on making progress rather than being perfect. Save what you can, and remember that every dollar you save now can help you avoid debt in the future.
Photo by astarot/Shutterstock
Leave a Reply