What is an emergency fund?
An emergency fund is money set aside to cover unexpected financial emergencies. Things like:
- You got a flat tire and had to pay for a tow and a tire
- You lost your job and have to pay your bills
- You need emergency gallbladder surgery
- You had a fire and need to rewire the electrical system in your house
- A family member passed away, and you need to purchase last-minute travel to the funeral
Unexpected financial emergencies are not:
- A down payment on a new car
- College tuition
- A great deal on a vacation
- Replacing your worn-out carpet with wood floors
- Normal wear and tear on your tires (this should be budgeted, not an emergency)
- A new TV for the Super Bowl
While these items may seem vital to you, an unanticipated financial emergency is something you had no clue would happen, so there was no way to prepare for it, which means you most likely had no money set aside to handle it.
An emergency fund eliminates the uncertainty surrounding where the money will come from. It gives you peace of mind so that if an emergency arises, you can concentrate on getting through it rather than worrying about how to pay for it.
How much should you have in an emergency fund?
The financial rule of thumb is to keep at least six months’ worth of spending in your emergency fund.
Of fact, everyone’s expenses differ, thus the monetary amount required to cover an emergency differs from person to person. Some people make sure their emergency money can cover indulgences, while others keep it simple and only cover the bills.
Use our free emergency fund calculator to figure out how much you should set aside.
Building up six months of savings may seem daunting, especially if you’re currently living pay cheque to pay cheque. But, before you panic and give up on saving anything, remember that an emergency fund is something you create over time. You aren’t going to save six months’ worth of spending overnight.
Begin small. Set an attainable goal that will not overwhelm you based on your ability to save. Make tiny changes, such as eating out less or buying used instead of new, and save the extra money.
Once you’re more comfortable saving, you can gradually increase your goal amount until you have enough money to cover six months’ costs.
Why do you need an emergency fund?
Maybe you have a great job with a good salary and believe that’s enough for you. But if the last few years have taught us anything, it’s to prepare for the unexpected. With inflation skyrocketing and a recession coming, an emergency fund is more important than ever.
Here are some examples of why you could need an emergency fund:
In case you lose your income. If you were fired tomorrow, would you have enough money to cover your living expenses until you found a new job? What happens if your company downsizes and you are laid off without severance pay? These are actual scenarios that can occur to anyone.
In case of a medical emergency. Even if you have health insurance, it does not cover everything.
In the event of a family emergency. Credit cards are not the ideal option right now, given the high interest rates. Even seemingly minor emergencies can devastate your finances if you don’t save money for them.
In case you require emergency house repairs. Even with insurance, you will be required to pay out of cash. Without an emergency savings fund, these expenses might bankrupt you.
Where to store your emergency fund.
If you’ve been saving money in a shoebox under your bed, pay special attention to this part.
Financial instructors frequently recommend that you open a separate account from the bank you use regularly. This keeps you from being enticed to withdraw money for non-emergency purposes.
You should also make sure it’s an account you can quickly access in case of an emergency, and that your money isn’t locked in.
So, what type of account should you open?
High-yield savings account
A high-yield savings account is comparable to a conventional savings account. The distinction is that it pays a substantially greater interest rate than the national average for savings accounts.
Traditional savings accounts are not intended to earn money. In contrast, a high-yield savings account doubles that amount a dozen times, resulting in a high rate.
However, these accounts are not the most convenient to use because they often require you to transfer the cash to a checking account before using them, which may cause a delay in obtaining them. However, this could be a good thing because the wait may be enough of a deterrent to leave the money alone.
Money market account
Money market accounts, like high-yield savings accounts, generate a higher annual percentage yield (APY) than ordinary savings accounts. These accounts are simple to use: some include a debit card, and you can even get checks!
Keep in mind that money market accounts, like savings accounts, have a monthly withdrawal limit and a greater minimum balance requirement than typical savings accounts.
Traditional bank account
This is the most commonly used account for emergency cash, owing to its ease of accessibility.
Traditional checking and savings accounts might not generate as much interest as money market or high-yield savings accounts, but they do earn some, and their convenience makes them ideal for dealing with a fast-moving emergency.
How to Build an Emergency Fund
You’ll want to perform some budgeting to ensure that you’re putting aside the correct amount in your emergency fund—not too little, but not so much that you’re sacrificing other things, such as paying off debts or simply enjoying life.
Here’s how to break it down:
Determine your objective savings goal. Use our emergency fund calculator to estimate how much money you’ll need to save to cover your monthly expenses for six months.
Calculate how much you can afford to save each month. You will need to construct a monthly budget to keep track of your present revenue and expenses. Determine where you can decrease costs or where you have additional funds to put aside for an emergency.
Pay yourself. Make sure you pay yourself just like you would your monthly payments! When payday arrives, transfer the amount you specified into your emergency fund account.
Make the most of unexpected opportunities. If you can’t decrease your spending any more and don’t have anything left over to save, you can use “surprise” or “found” money to grow your emergency fund. Tax refunds, employee incentives, and money received as a gift are common sources of recovered money.
Revisit and revise. Everyone has varying monthly expenses. Review your budget regularly and make any necessary adjustments. Your emergency fund will be useless if you put so much money into it one month that you can’t afford groceries for 30 days, or if you’re forced to skip credit card payments and pay exorbitant interest rates.
The wrong kinds of emergency funds
People frequently replace their emergency savings with one of two options. Do not do it. While they will provide you with the necessary funds in the near term, you will end up paying more in the long run.
Do not use your retirement money and investments.
Most people’s principal financial asset is their retirement account, and for many, it is their sole source of significant savings. As a result, you may be tempted to use those assets in an emergency, but doing so will have serious consequences.
Pulling from your retirement funds may temporarily meet your monetary needs, but it may result in an increased tax liability the following year. At a minimum, you must pay regular income tax on the amount withdrawn. However, if you are under the age of retirement, you may be subject to a 10% early withdrawal penalty, depending on the circumstances.
Those with investment accounts may be under similar pressure to sell stocks or funds to raise cash in an emergency. However, you will incur financial implications. Either you’ll sell those investments at a loss, locking in the loss, or you’ll sell them at a profit, resulting in capital gains tax liabilities.
Don’t tap credit lines
Many investment consultants encourage their clients to be “fully invested.” The logic is that because stock returns are so much larger than fixed-income assets, saving money is a surefire way to lose money.
From a financial standpoint, that counsel is sound. However, many people in such situation use credit lines as an emergency fund.
The difficulty with this technique is that it just shifts the demand for cash from the now to the future. Sure, credit lines will satisfy your immediate monetary needs, but you will have to repay them later.
Either you refund the money in large lump sums, or you include a new semi-permanent monthly payment in your budget.
The bottom line
Having an emergency fund provides financial peace of mind. Knowing that you have enough money to meet an emergency minimizes the financial uneasiness that comes with being unprepared. Even if you have to start saving in tiny amounts, getting started is crucial.