Table of Contents
Do You Have an Emergency Fund? Tips for How to Get Started
Many Americans go into debt as a result of unexpected expenses each year. In fact, in a frequently quoted study by the Federal Reserve, in 2017, 40% of Americans couldn’t afford a $400 unexpected expense without selling something or going into debt.
Enter: the emergency fund, the hidden hero of your financial plan. An emergency fund is your financial safety net, a supply of funds saved to protect you from debt in the face of an unexpected financial crisis. By starting an emergency fund, you can take important steps to prepare for the financial burdens that come your way when you least expect them.
The thing about emergencies is that they’re impossible to predict – and, by nature, wreak unprecedented havoc. Today, we’re adding defensive skills to your financial toolbox. What is an emergency fund, and how do you build it? Keep reading to learn the answer to this question and more.
Building an Emergency Fund
An emergency fund is a stockpile of easily accessible money that you save for unexpected, difficult financial situation like job loss, auto accidents, large medical expenses, or employment interruptions. With a well-established emergency fund, you can manage these kinds of expenses without going into debt or having to sacrifice critical assets and investments, like your house or retirement fund, to stay afloat.
An emergency fund is not for everyday savings goals, like making a large purchase or covering predictable bills. Rather, your emergency fund should be saved for the worst-case scenarios in order to protect you from severe debt. Unfortunately, you can’t plan when an emergency will happen – and the last thing you want is to have spent your full emergency fund on a fancy car the week before an unexpected emergency room visit.
The only thing predictable about emergencies is that they do happen. With this in mind, building up your emergency fund should be one of your top financial priorities. Financial experts recommend prioritizing an emergency fund over paying down low-interest loans like student loans and car loans, and mortgages. Moreover, your emergency fund is so important that you should consider it in-line with paying down high-interest debt – such as credit card debt – and saving for retirement.
How Much Should I Save for My Emergency Fund?
Financial experts recommend that your emergency fund hold at least 3 to 6 months of expenses. As you calculate your target goal, take into account the following:
- Your monthly living expenses: the minimum amount you have to spend on groceries, utilities, your rent or mortgage, insurance, and transportation in any given month.
- The strength of your preexisting safety net, i.e., your disability insurance, health insurance, and life insurance policies – the stronger your coverage under these policies, the less you’ll need to have in your emergency fund.
- Your risk tolerance: how well-suited you are to weathering financial hardship.
You should also consider factors such as your job security, the number of income streams in your household, and your access to other savings.
As your life changes, your ideal emergency fund total will change as well. Your monthly expenses will grow as you take on more financial responsibility, like having children and owning a home, so you’ll want to make sure your emergency fund appropriately reflects the amount of money you’ll actually need in case of an emergency.
A 2019 study by economists Jorge Sabat and Emily Gallagher suggests that as little as $2,467 (about one month of income for a lower income family) can be enough to make a difference in dealing with a financial hardship. If your initial emergency fund target goal feels overwhelming at first, remember that each dollar you deposit towards that goal is a dollar that could save you from financial ruin.
How Do I Start an Emergency Fund?
It is vitally important to consider carefully where you place your emergency fund. You’ll want to find your ideal balance of liquidity – how easily your savings can be converted into cash – and interest.
To be sure, start your emergency fund in a bank account that’s separate from your “go-to” account to avoid tapping into it for unnecessary expenditures. You might consider a few different venues for your emergency fund, each of which has its own benefits:
- The under-the-bed method: The most liquid placement of your emergency fund is in pure cash. In an emergency, having $20 or $2,000 saved in a safe place in your home will ensure that you have the money when you need it. Of course, you will not earn any interest on this cash stock, which means that its buying power may diminish over time via inflation.
- A brick-and-mortar bank: In terms of liquidity, your next-best option is your local brick-and-mortar bank. Your local bank will offer some interest, while also being readily available.
- Online banks: Online banks typically offer the highest yields of interest, allowing your emergency fund to generate additional funds while not in use. However, it can be a pain to actually get that cash – pulling out cash may require you to transfer funds to a checking account first, a process that may take a couple of days. If you want to put your emergency fund in an online bank, it would be wise to supplement it with more liquid savings to remediate this time lag.
Should I Invest My Emergency Fund?
Although investing your emergency fund to make money is tempting, once more, you’ll want to consider the fund’s liquidity. Factor in that, should a nationwide emergency (such as the 2019-20 Coronavirus) occur, the fund’s stability may be compromised. By investing your funds, you risk losing more than you have earned due to the volatility in the market – a gamble you don’t really want to make with your financial security net.
Most folks will end up keeping their fund in a savings account, which has an average return rate of 0.1%, or investing in a certificate of deposit, with a rate of return in the range of 0.35-2.00%, depending on the length of the investment.
If you feel prepared to take on greater risk with your fund and want to try investing it in more lucrative options, only do so when you have added an additional safety cushion of 25-30% more than you need to cover your expenses. And if you’re not sure how much risk to take on, consider investing just a portion of your fund while putting the rest in a savings account. You may find that the gains you’re having on one account, even if small, may be enough to cancel out the rate of inflation eating away at the other.
Other Things to Consider
While starting an emergency fund is the first way to ensure your financial security in the future, there are other things to keep in mind to ride out the storm of a financial emergency.
The Importance of Insurance
Make sure you have adequate homeowner’s or renter’s insurance and life insurance to protect your home, your belongings, and your family in a disaster or sudden death. And invest in a medical insurance policy that prevents you from paying large medical bills out of pocket. The costs for these policies vary, but having no coverage at all could impact your saving significantly if an emergency does happen.
The Importance of Good Credit
Having a high credit score can help you get approved for loans and new credit cards that you may need to weather a financial storm; however, be responsible with your new line of credit, using it for the essentials only.
The Importance of Keeping Your Retirement Fund Intact
Although it may be a tempting resource to tap into when times get tough, if possible, leave your IRA or 401(k) alone. You could be putting your future financial goals in jeopardy, and the taxes and penalties you’ll face for early withdrawal will be a hit to the savings you’ve accumulated.
An emergency fund should be one of your top financial priorities, ranking higher than paying down debt quickly or saving for a down payment on a house. With even a small emergency fund established, you can help protect yourself from accruing more debt in a financial emergency, which will enable you to pay down existing debt or save for future goals.
Don’t worry if the concept of saving a full emergency fund seems unachievable – building an emergency fund is a noble and ambitious project and, rightfully so, takes time.
When times get tough, it can be reassuring to know that you’re prepared. By starting an emergency fund today, you can create a safety net to ease your burdens during times of financial stress. Keeping your fund at your desired balance and replenishing funds if you do need to use them can make a difference in the financial security of your future.