Building an emergency fund might require time and some sacrifices, but it’s a crucial step in your financial life. Here’s what you need to know.
However, true financial security also means planning for things you can’t predict.
Whether it’s something global like a pandemic or economic recession, or an emergency like an unexpected medical bill or car trouble, having a financial cushion to fall on can be crucial. That’s why so many financial experts stress the importance of having an emergency fund.
Read on to learn how an emergency fund works, how much you need to have and how to save for it.
Emergency fund: What you need to know
What is an emergency fund?
An emergency fund is a highly liquid savings reserve, readily available when you face unexpected life events such as unemployment, costly home or car repairs and medical expenses.
“An emergency fund is funds set aside to cover the cost of unexpected, and often expensive, events,” Timothy E. Hansen, CEO of Wealth Growth Wisdom, explains. “It is saved to be used for real, urgent needs such as paying rent when your income dries up or to foot a medical bill without having to rack up a balance on your credit card, take out loans or tap into your home’s equity.”
While it’s good to have multiple savings goals, it’s wise to keep your emergency fund separate from them. This means it’s not to be tapped in when you need money for vacation or any other luxury that can wait. It may be tempting to spend the funds that seem like they’re just sitting in your account, but it’s important that they stay there.
In fact, having money saved for a rainy day can be critical to your financial health.
Why should creating an emergency fund be a top priority?
When a financial emergency happens, it’s usually not something you’ve planned for. Whether the roof in your home starts leaking, you have to pay for an ER visit or you find yourself out of job, it’s probably something you haven’t anticipated.
Yet, it’s also something your budget needs to be prepared for.
“With all the turmoil surrounding the COVID-19 crisis, people have become acutely aware of the term ‘emergency fund,’” says Lamar Brabham, CEO and founder of Noel Taylor Agency. “An emergency fund is an account that every working person should build. It exists for the expressed purpose of saving your financial life if things unexpectedly fall apart.”
According to Brabham, without access to an emergency fund, people are likely to pull funds from 401(k)s, IRAs or brokerage accounts if an emergency arises.
“Pulling money from these accounts often involves steep penalties for early withdrawal, and if your investments are down at the time with withdrawal, you could be damaging your financial future even more,” he explains.
Many also get into debt when in need of cash. Some view their credit cards as a source of emergency funds, others might consider taking out a personal loan.
While it’s natural to turn to your cards when you have no other means to get cash, credit card debt tends to get expensive and can land you even in more financial trouble. Not to mention, your credit can get damaged as a result.
Try to prevent this from happening by building a financial safety net – and making it a priority.
How much should an emergency fund be?
Generally, financial experts recommend having three to six months of basic expenses in your emergency fund. Such expenses include rent or mortgage payments, food, car payments and other essential bills. Lifestyle expenses, such as streaming subscriptions or eating out, shouldn’t be considered when you’re determining how much you need in your emergency fund.
Three to six months of expenses can be a good amount to aim for, since this is generally how long it takes to secure employment in case of job loss. However, every situation is unique, and even finance experts will give you different answers on how much you should have saved, ranging from $1,000 to 12 months of expenses – or more.
One way or another, it’s important to make sure you have some kind of financial cushion. The main thing is to start saving and stay committed to it.
It can seem overwhelming at first, especially living paycheck to paycheck, as many do. Building up an emergency fund is not an easy task, especially if you don’t have much left after paying all your bills. For that reason, it’s recommended to set a smaller goal – like $1,000 or a month worth of expenses – and bump it up after you’ve reached it.
How to save for an emergency fund
Saving up for an emergency fund requires patience, as well as creating enough room in your budget to dedicate to it.
It’s best to set up an automatic biweekly or monthly deposit into a savings account. That way, you’ll have a designated place for your emergency fund and contribute to its growth consistently.
If it doesn’t seem like something you can commit to at the moment, Cristina Yasakci, credit expert at Credit Achievers, suggests making budget cuts.
“Small budget cuts lead to big savings!” she says.
Here are a few examples Yasakci offers on how you can make such cuts:
- Try to decrease your dining out trips. Have impromptu potluck parties if you miss the social aspects of dining out.
- Have a movie night in instead of going to the theater. With the many options of streaming services and big screen TV’s with surround sound, you can have a fun party at home with some great homemade popcorn, soft drinks and a plate or two of nibbles that you can pull together for a fraction of what you would pay at movie theaters.
- Experiment with your own coffee flavors at home. If you spend roughly $5 for a cup of Starbucks coffee every work day, you’re out $100 a month.
- Avoid shopping at gas stations’ check-out counters. Try to buy your snacks at a discount grocery store beforehand. Make a list of the items you and your family like. You can also prepare cold lunches to take with you to work.
There are many ways you can help your emergency fund grow, little by little. For instance, if you have a cash back card, you can also use it as a savings tool. Make sure not to carry a balance to get the most out of your rewards, and put all the cash back you earn into your rainy-day savings.
Building your emergency fund often requires creativity, and sometimes you have to make lifestyle sacrifices. But in the end, having this money cushion is the foundation of your financial safety.
Where to put your emergency fund
Your emergency fund needs to live separately from the checking account you use for everyday expenses. At the same time, it needs to be readily available when an emergency strikes. A savings account or a money market account are good options.
Adam Beaty, certified financial planner at Bullogic Wealth Management, works with young professionals and helps his clients establish emergency funds.
“Remember, you need to have some emergency fund in place that is not touched until a true emergency happens,” he says. “We love using high-yield online savings accounts as way to make a little interest but to also keep the account hard to reach.”
Building up an emergency fund isn’t always easy and may take quite some time. However, it’s an important part of your financial security that can become the difference between a little financial bump and a complete disaster that puts you in debt for a long time.
“Trust me,” Beaty says, “when times get tough and you can fall back on your fund, you will be thankful it is there.”