If you lost your job tomorrow, do you know how you’ll pay the rent next month?
If your car’s transmission broke and required a $2,000 repair to be back on the road, could you pay the bill without going into debt?
For more than half of Americans, the answer is no. And chances are, among us younger (and poorer) Americans, the percentage is higher.
The answer to both of these potential problems is to have a good chunk of money set aside in savings…a rainy day fund if you will, or as we financial nerds call it: an emergency fund.
Emergency funds are like insurance: confusing and boring, but downright necessary. You shouldn’t drive without car insurance and, quite frankly, you shouldn’t try to live life without emergency savings.
If you, like many Americans, haven’t been able to save an emergency fund or have put it off because you don’t think you’ll need one, consider what you would do if suddenly you found yourself with a $1,500 repair bill or, worse, without an income.
Emergency funds could be the most vital part of your financial plan, so you really owe it to yourself to make a plan to build yours today. We’ve put together a step-by-step guide to creating your very own emergency savings—from the initial buffer to the fully-funded emergency fund.
WHAT IS AN EMERGENCY FUND?
Before we break down exactly what an emergency fund is, let’s define what it is not:
- It is not used forplanned purchases like a house, a new car, a college education, and so on.
- It does not have to a large, unattainable amount; it can start small.
- It is not a set amount for everyone—it varies based on your lifestyle.
Now that you know what it’s not, let’s talk about what it is.
WHY YOU NEED ONE
An emergency fund serves two major purposes:
- It creates a financial safety net during emergencies like a job loss, illness, or major unexpected expense.
- It allows you to avoid the use of credit cards or loans during said emergency.
Unfortunately, there are plenty of times you may need an emergency fund. Some may be scary and severe—like a job loss or chronic medical condition—but others are simple expenses that you just weren’t expecting—like a car or home repair.
Now that you know exactly what an emergency fund is and why you need one, it’s time to look at building it!. Here at Money Under 30, we think that savings “buffer” of $500 to $800 is the best way to start.
Step 1: Build a Buffer
Last year, we wrote about 6.5 half steps to financial stability. The first and arguably most important step is to build a savings buffer of $500 to $800.
If you’re in debt, it’s tempting to throw every extra penny towards your debt. However, it’s better the build at least a small buffer of $500 to $800 dollars in savings before attacking your debt.
Those amounts may seem small, but when you’re in debt, they’re really not. When I was in debt and living paycheck to paycheck, I couldn’t seem to save even $100. Whenever you feel like you’re making progress, something comes up and you fall behind again.
So if you can’t even get ahead in your debt payments, how will you ever save extra money on top of that?
There are three primary ways to scrape together extra funds to build your primary buffer before you start tackling your debt payoff and, later, building a stronger emergency fund.
- Reduce discretionary spending
- Cut recurring expenses
- Earn more
You can choose to focus on one of these items or all three to scrape together any extra cash you can.
Cutting back is easy for some people, but it just doesn’t work for everyone; that’s why building an extra income stream is vital if you can’t seem to find any extra dollars to build your buffer. Whether it’s picking up a couple extra hours at work, creating a freelance business, applying for a part-time job or creating an online store, figure out what fits best with your available time and skills.
Here are some great articles that break down tips on how to earn more money:
- Deciding to Earn More [Money Under 30]
- Infographic: The 3 Easiest Ways to Earn More [I Will Teach You to Be Rich]
- Make More Money: How To Super Charge Your Income [Get Rich Slowly]
And by the way, in case it’s not obvious, you don’t need to get a second job or start freelancing to earn enough cash to start that emergency fund…it could be simple as finding a few things you don’t use anymore and selling them on Craigslist or eBay.
WHERE TO PUT THAT MONEY
If you ever do have the need to use your emergency fund, you’ll need access to the fund quickly if not immediately.
This is why you shouldn’t maintain your mutual fund in stocks, CDs or bonds—you’ll need to keep your emergency fund liquid. The best and easiest way to do this is by using a basic savings account, either online or at your local bank. We recommend keeping the account at a different bank than your primary checking account to reduce the temptation to tap it for non-emergencies.
Remember, an emergency fund is for security, not earning a return. While you should absolutely get the best interest rate you can find while keeping your money accessible, don’t be tempted to chase yields and lock up money you might need tomorrow in an investment that may be more difficult to liquidate.
HOW MUCH DO YOU NEED?
Everybody—financial experts and amateur advisors alike—has a different opinion on how much money you should keep in your emergency fund.
In general, however, your ultimate goal should be to have enough money in an emergency fund to pay your essential expenses for several months. Some experts say six months, others nine, or twelve.
We recommend figuring out what makes you comfortable. You can get started by downloading our emergency fund spreadsheet.
At the very least, you should have enough money set aside to cover a big unexpected expense without turning to credit cards. Then, ideally, you would have enough money to get you by in case you lost your job and had to find a new one.
(Hint: The more difficult you think it will be to find a new job in your field, the more you may want to save!)
Step 2: Build Your Emergency Fund
Once you’ve created your buffer—and completed steps two and three in the 6.5 Steps to Financial Stability list—it’s time to start building a sustainable emergency fund.
Building the emergency fund will be very similar to creating your initial buffer. If you’ve already reduced spending and/or created extra income, a percentage of that cash should go to your emergency fund.
Here are some helpful tips (in addition to reducing spending and/or earning more) for building that emergency fund:
- Direct Deposit. If you’re tempted to spend extra cash, set up a direct deposit into your separate emergency fund account. (Pay yourself first.)
- Bill Yourself. If you don’t have access to direct deposit, treat your monthly emergency fund allotment as a bill—like rent or your electricity payment. Remember to deposit that amount into your savings on whatever day of the month works for your situation. (Same idea as above—pay yourself like any other bill).
- Add Bonus Money. Use things like tax refunds, mail-in rebate checks, or unexpected windfalls to add a boost to your e-fund.
Here are some more ideas:
- Three Little Ways To Boost Your Emergency Fund [Money Under 30]
- 50 Tips to Help You Establish Your Emergency Fund [Consumerism Commentary]
- 22 Way To Build An Emergency Fund [BankRate]
Establishing an emergency fund may not be the most fun or exciting part of creating financial stability, but the safety net it creates is worth more than the actual dollar amount it contains. It’s the first step towards financial freedom that can keep you on the right financial path even if life’s events try to knock you off.
Ask Your Question About Emergency Funds
What do you want to know about emergency funds? I’m sure there are plenty of questions we haven’t covered, so ask yours in a comment and we’ll select the best ones to answer. Other readers may have some good ideas to share in response, too. Leave your question in a comment now.