Oct 27, 2023
How to Set Up an Emergency Fund
Three to six months of living expenses can be a lifesaver in times of uncertainty.
An emergency fund is your financial safety net for life’s unforeseen twists and turns. By setting aside enough money to cover large expenses in a savings account, you can ensure your financial well-being and land on your feet no matter what the future holds.
|What is an emergency fund?|
An emergency fund is money you set aside to pay for large, unexpected expenses. The idea behind emergency savings is that you don’t have to go into debt or derail your saving and investing plans when life throws you a financial curveball. Your emergency fund acts as a buffer against unforeseen hardships like job loss, medical bills, and travel emergencies, ensuring that you remain stable and on track to your financial goals.
In this article, we’ll cover:
- Why you need an emergency fund
- When emergency funds come in handy
- How much you should save up
- How to build your emergency fund
- Where you can keep your savings
- Emergency savings vs other savings
Why you need an emergency fund
Without emergency savings, you wind up sacrificing your future plans to stay afloat during a time of need. Think of your emergency fund as a double-pronged defense: it protects you in the moment when unforeseen expenses arise and safeguards your ability to build long-term financial health.
- Avoid racking up debt: An emergency fund prevents you from relying on credit cards or loans for unexpected expenses, so you don’t have to accumulate debt, pay interest on loans, or risk damaging your credit score.
- Don’t deplete your savings: Instead of withdrawing money you’ve earmarked for other savings goals, an emergency fund ensures you have a separate cache in case of a crisis.
- Protect your investments: With an emergency fund, you won’t be forced to liquidate investments before you’d planned to, potentially taking a loss in the process.
- Maintain peace of mind: Knowing you have money in reserve reduces the worry that a financial emergency could undermine your financial stability, especially during challenging times.
When to use an emergency fund
An emergency fund is a safety net to cover large expenses, generally over $1,000, or to sustain you if you lose your income. It’s crucial to use it only when it’s truly urgent and necessary; if you deplete your emergency savings for non-essentials or to cover normal monthly expenses, the money won’t be there when you genuinely need it.
An unexpected expense is just that: unexpected. That means you can’t necessarily anticipate what you’ll need emergency savings for. That said, there are some common scenarios in which people rely on an emergency fund.
- Major car repairs: Situations like a car accident, engine failure, or a transmission issue can all pose a high financial toll.
- Home repairs: Whether you’re a homeowner dealing with a failing furnace or a renter fighting a bedbug infestation, unexpected home repairs can be costly.
- Medical emergencies: Health is unpredictable. From sudden surgeries to treatments not covered by insurance, medical expenses can take you by surprise.
- Unplanned travel: Sometimes, urgent trips are unavoidable. Whether it’s attending a family emergency, a funeral, or assisting a sick loved one, having funds set aside can ease the journey.
Even the most stable-seeming job can go up in smoke, so it’s important to be prepared for the possibility of unemployment. If you face a sudden loss of income due to layoffs or health issues, an emergency fund can help cover your living expenses without going into credit card debt while you find a new job.
Emergency cash is especially crucial if you’re self-employed or a gig worker, since government financial aid options like unemployment or disability benefits might not be available to you.
How much money should you have in your emergency fund?
A widely accepted rule of thumb is to keep three to six months’ worth of living expenses in your bank account for emergencies. The reasoning is that it can take many months to find a job, so you want to have enough to cover your living expenses in case of unemployment.
The exact amount for a healthy emergency fund will vary for everyone. To get a ballpark figure for yourself, jot down all your monthly expenses and multiply that by three (for the conservative side) or six (for a more comfortable cushion). The number you come up with might seem like a lot of money, and you may want to whittle it down by subtracting expenses you’d temporarily cut if you lost your job, like entertainment or treats.
For example, say your total expenses add up to $5,000 a month. You’d need between $15,000 and $30,000 in your emergency fund to cover three to six months of living expenses. But if you were to remove some discretionary spending from your budget, you may find that $10,000 or $20,000 would be enough to get by if you tighten your belt.
In reality, however, six months of living expenses sounds like an intimidating savings goal for most people. The good news is, you don’t need a specific amount of money to start an emergency fund. If you just start saving a portion of your paycheck based on what you can afford, your fund will grow over time.
How to build an emergency fund
Like any financial goal, building an emergency fund may sound daunting at first, but it’s much more accessible when you have a plan and tackle it in small chunks.
The key is saving consistently and gradually increasing your contributions as you’re able.
Make a budget you can stick to
Building a budget is the foundation of managing your day-to-day spending, paying down debt, and working toward your savings goals. There are many different budgeting strategies out there, such as the 50/30/20 rule, the envelope method, and zero-based budgeting. The best approach for you is the one you can stick with. Include a line item in your budget specifically for your emergency fund so you’re adding to it bit by bit every month.
Automate your savings
One of the smartest moves you can make for your savings is to automate your contributions. By setting up a direct deposit from your paycheck into your savings account, you can tuck a portion of your earnings directly into your emergency fund before you even see it, thereby reducing the temptation to spend that money. Over time, this consistent, automated approach can significantly grow your emergency savings without feeling the pinch.
Take advantage of windfalls
Sometimes life drops a financial bombshell, but every so often you get a pleasant surprise as well. Windfalls like tax refunds, bonuses, and gifts are an opportunity to bolster your emergency savings. When you find yourself with extra money, consider channeling a portion into your emergency fund. Allocating windfalls to your savings can accelerate your fund’s growth, getting you closer to your financial goals without affecting your regular income.
Trim your expenses
Every dollar saved can be a dollar earned for your emergency fund. By reviewing and cutting back on non-essential expenses, you can free up more money for your savings. From cutting back on discretionary spending to reducing the cost of monthly expenses, look for practical ways to save money and funnel the extra cash into your emergency savings. Even small changes can make a noticeable difference in growing your emergency fund.
Where to keep your emergency fund
When storing your emergency savings, two principles are key: liquidity and growth. Liquid means you can access your funds quickly and easily, without facing penalties. And growth is all about earning money on your savings.
While it’s essential for your emergency cash to be accessible, you don’t want it to sit idle in your checking account. Opting for an interest-bearing savings account can help your emergency fund grow more quickly without you having to lift a finger.
- Savings accounts: A traditional savings account offers a safe place for your money, typically with minimal or no fees. Many banks offer options with a low minimum required deposit; the trade-off is that these bank accounts usually pay lower interest than other short-term ways to grow your money.
- High-yield savings accounts: These are similar to regular savings accounts, but offer a higher interest rate. This means your money can grow faster over time. Some might have higher minimum balance requirements or monthly fees, so be sure to read the fine print.
- Money market accounts: A money market account combines features of both checking accounts and savings accounts. Typically offering higher interest rates than standard savings accounts, they may also come with checks or debit cards. However, they might require a higher minimum balance and have monthly limits on transactions, making your emergency fund less liquid.
Emergency savings vs. other savings
Saving money is all about planning for the future, whether it’s unanticipated expenses or things you know you’ll need or want. An emergency fund is one component of an overall savings strategy; be sure you understand how it differs from other types of savings funds so you can plan accurately for all your financial goals.
- Emergency fund: Emergency savings are for unexpected and significant expenses, typically those over $1,000, or even much more.
- Rainy-day fund: Tailored for smaller unforeseen expenses, a rainy-day fund can cover living expenses you may not have accounted for in your budget. For instance, if there’s an out-of-the-blue spike in your water bill or a surprise visit to the vet, this fund comes to the rescue.
- Sinking fund: This is your planned savings pool. It’s for anticipated expenses you know are coming down the road, like regular vehicle maintenance, holiday gifts, or a vacation. When you have a solid emergency fund, you can rest assured you won’t have to siphon money away from these savings goals if you’re in a financial pinch.
- Retirement savings: Preparing for your golden years is a marathon, not a sprint. Many people opt for tax-advantaged retirement accounts like IRAs or 401(k)s to maximize their savings. Withdrawing funds early can have substantial financial repercussions, so it’s extra important to rely on your emergency fund instead of tapping into retirement savings in a crisis.
Protect your present and future with an emergency fund
An emergency fund equips you to navigate life’s uncertainties with confidence. And it also prepares you to work toward your longer-term financial health. Knowing you have a buffer to weather a financial storm empowers you to focus on saving and investing money to reach your bigger goals.
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