Picture this – It's the middle of winter, and your furnace breaks down, or you have a great job, but the markets crash, and you are laid off.
These are bleak scenarios that no one wants to imagine happening to themselves, but will you be financially prepared if it ever did? If not, then now is the time to start building your emergency fund.
This article will discuss what an emergency fund is, why you need it, how much money is required in an emergency fund, and how to get started.
What Is an Emergency Fund?
An emergency fund or rainy day fund is money you set aside to prepare for unforeseen expenses or emergencies. You can use it to pay for unexpected expenses, such as car repairs, home repairs, replacing your furnace, or replacing your income in case of job loss or unemployment.
An emergency fund would not be something you would use to fund your wishlist, like vacations and other discretionary expenses.
Why Is an Emergency Fund Important?
Emergency funds are an essential part of any financial plan. They provide a cushion in case of unexpected expenses or emergencies. Take the Covid-19 pandemic as an example. It may be slowing down, but thousands of people lost their jobs or were hit with unexpected medical bills. Not all of them were prepared.
As per a Bankrate survey, over 25% of Americans do not have any emergency savings at all. Out of the 75% who have an emergency fund, most do not have enough savings to last three months.
Emergency funds can help you in unexpected financial emergencies. Without it, you may have to borrow money or use your credit cards to pay for unforeseen expenses, leading to debt and financial problems. Prepare yourself, so you do not find yourself in a similar situation.
How Much Money Is Required in an Emergency Fund?
Most experts recommend having at least three to six months' worth of living expenses saved in an emergency fund.
While the 3 to 6-month recommendation is a good rule of thumb, consider it a minimum baseline and do your assessment to determine how much money you may need in an emergency. You may want to save more money if you have a higher risk of emergency expenses.
Some of the things that you should consider are:
How Many Dependents Do You Have?
The more dependents you have, the more money you would need in the case of an emergency. You can set a goal of a fixed amount per member of your household or simply choose to save a percentage of your salary.
What's the Age of Your Dependents?
Your savings goal will need to be different if you have college tuition to pay for versus if you have a newborn child. A similar consideration is if you have elderly parents with medical expenses.
How Many Sources of Income Do You Have In Your Household?
If you are a multi-income household, the risk of losing all sources of income at the same time is lower.
How Stable Is Your Income or Job?
Are you part of a seasonal industry or on a temporary contract? Does your profession put you at a high risk of injury? If so, you may want to save a more significant portion of your income in an emergency fund.
What Is Your Family History of Illness?
If you are at a higher risk of illness, you may want to pad your savings to prepare for the future.
For many families impacted by unemployment or illness during the COVID-19 pandemic, even six months of savings in an emergency fund may not have been enough to get through it unscathed. It is best to analyze your situation to determine how much money you want to save in your emergency fund.
Don't worry if your savings goal is a considerable number. The idea is to start the process and build it up slowly. For example, it took us almost five years to build our emergency fund to cover 12 months of expenses.
How To Build an Emergency Fund?
Now that you understand the importance of saving for emergencies, it is time to start planning and building your own savings fund.
Follow the steps here to get your emergency fund started/set up.
1. Determine Your Emergency Fund Goal
How much money do you want to have saved for emergency use? Use the 3 to 6-month guideline to get started or analyze your personal needs to set a goal.
2. Set up a Monthly Budget
Document all your monthly income and expenses to determine what you can afford to put into your emergency fund every month. It does not matter if the number is small, to begin with; any savings is better than no savings.
3. Open a Savings Account
Online savings accounts tend to offer the best interest rates, so do a Google search to find ones that provide the best rates and can be linked to your regular bank's checking account for ease of transferring money. You can also look for safe investments to boost your returns, but make sure to talk to your financial planner and do your research first.
4. Automate Monthly Savings From Your Salary/Paycheck
Have a fixed sum automatically transferred from your checking into your emergency fund savings account every month. This way, you won't be tempted to spend the money, and it will grow without you having to do anything extra.
A well-funded emergency savings account is key to financial security. By following the steps above, you can ensure that you are well on your way to achieving your savings goal.
5. Reinvest Any Interest Earned
If your emergency funds earn interest, do not withdraw the interest. This allows your emergency fund to grow over time and earn compound interest on the principal and the reinvested interest amount. Simply put, do not take any money out of this account unless you have to. It will propel you to reach your goal much faster.
Additional Steps To Maximize Your Savings for Protection From Financial Emergencies
If you are concerned about your limited income or taking too long to achieve your savings goal, don't worry too much about it. The hardest part is getting started and sticking to your budget. Any amount of savings will help you in a bind.
In general, expect it to take 2 to 3 times the number of months to save up enough. For example, it can take 6 to 9 months to save enough money to last three months in an emergency. There are ways to speed up the process, though. Here are some additional steps to take to maximize your savings.
1. Draw a Line Between Emergency and Everything Else
Do not touch your emergency fund for anything except true emergencies. For example, is it an emergency if you overindulged one month and have a large credit card bill to pay? When it comes to emergency expenses, you should always exhaust all other options before dipping into your emergency fund. That means getting a loan from family or friends, or using credit cards to cover the cost. If you need to use money from your emergency fund, make sure you pay the money back as soon as possible.
One method to keep your emergency fund segregated is to create a savings account at a completely different bank or financial institution than your regular one. This way, it won't be straightforward to transfer money and pay off bills with your emergency funds.
2. Save Windfalls
If a financial emergency happens, you will want to ensure that your emergency savings are well stocked. Besides regular savings and deposits, a great way to top up your fund is to save any windfalls you may receive, such as an annual bonus from work, holiday cash gifts from family, or an inheritance. These large deposits can greatly decrease the time it may take you to reach your savings goal.
3. Annual Tax Refunds
Another way to help pad your emergency savings is by using your annual tax refund. If you're expecting a sizable refund, consider depositing the money into your emergency fund instead of spending it. You'll be happy you have the extra cash in case of an emergency.
4. Cut Out Discretionary Expenses
Cook more at home, buy clothes less often, take one less vacation; all these are ways to reduce your expenses till you save up enough money for emergencies.
5. Build an Additional Income Stream
Another way to protect yourself from financial emergencies is by building an additional income stream. This could be through a side hustle or earning extra money through investments. Having a secondary, stable source of income will help you cover any unexpected costs that may arise.
Many people take up temporary or part-time jobs to help them get to their financial goals faster. Just ensure that any side hustle or business you start does not add hefty expenses to your budget.
6. Get Cashback
Many people nowadays use cashback credit cards to get money back on their everyday purchases. Why not use a cashback card to help you save for your emergency fund?
You can easily earn $100 or more in a year just by using a cashback card for your regular expenses. It may not seem like a lot of money, but every dollar helps.
7. Save the Change
If you want to make it easy to save, sign up for one of many apps that round up your purchases to the nearest dollar and invest the spare change in low-cost ETFs.
Where Should I Keep or Invest My Emergency Fund?
Your emergency fund should ideally be kept in a no-risk account where it will be easy to access in case of an emergency.
We recommend a high-interest savings account. This is by far the most popular option to keep emergency savings. Not only is it safe, but you can also get a decent interest rate on your deposits as well. Ensure that the savings account is easy to access, has no monthly fee, no minimum deposits required, and is FDIC insured.
Some experts recommend investing emergency funds in money market accounts, short-term certificates of deposit, or Treasury bills to get higher returns on your money. Each one of these comes with some rules and restrictions. Some have penalties for early withdrawal and lock-in periods. Do your research and read the fine print before making your decision.
We do not recommend investing your emergency funds in stocks or other risky investments.
Start Now! Emergencies Don't Come With a Warning.
Building an emergency fund can seem like a daunting task, but you can make it a reality by following the steps above. Remember to be patient and stay focused on your goal. With a little bit of hard work, you'll soon have enough money saved up to cover any unexpected expenses.
Ash & Pri are the Founders of AshandPri.com where they empower others to make smart money decisions across all aspects of life. They achieved financial freedom in their 30's and have traveled to over 30 countries, thanks to a disciplined approach to money management. Both hold an MBA degree and have 13+ years of experience in financial services, consulting, and telecommunications.