It doesn’t take a global pandemic to justify needing an emergency fund. Maybe your house gets flooded. Maybe your dog eats a bag of chocolates. Maybe you need to fly cross-country to visit an ill family member.
All these things could put a serious dent into your budget, which is why you need an emergency fund.
Here’s what you need to know to start building one.
What is an emergency fund?
An emergency fund is money you have set aside for unexpected financial emergencies. Things like:
- You got a flat tire and had to pay for a tow and 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 house
- A down payment on a new car
- College tuition
- A great deal on a cruise 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 things may seem important to you, an unexpected financial emergency is something you had no idea would happen, so there was no way to plan for it — meaning, you probably had no money set aside to cover it.
An emergency fund takes the guesswork out of where that money will come from. It gives you peace of mind so that if an emergency does pop up, you can focus on getting through the crisis — not on how you will pay for it.
How much should you have in an emergency fund?
The financial rule of thumb is that you should have at least six months’ worth of expenses in your emergency fund.
Of course, everyone’s expenses are different, so the dollar amount of how much you need to get through an emergency varies from person to person. Some people make sure their emergency fund can cover luxuries while others stick to a more bare-bones fund that provides just enough to pay the bills.
To help you calculate how much you should save, use our handy emergency fund calculator.
Building up six months of funds may seem like a lot, especially if you’re currently living paycheck to paycheck. But before you panic and throw in the towel on saving anything, keep in mind that your emergency fund is something you build over time. You’re not going to save six months’ worth of expenses overnight.
Start small. Set an attainable amount as a goal that won’t stress you out based on what you can afford to save. Make small changes, like eating out less or buying secondhand instead of new, and stash away that extra cash.
Once you get more comfortable saving, you can set higher and higher goal amounts until you have enough money to cover the six months’ expenses.
Read more: How to make a budget
Why you need an emergency fund
Maybe you have an excellent job with a decent income, and you think that’s enough for you. But if there’s one thing the past few years have taught us, it’s to expect the unexpected. And with inflation sky-high and a recession looming, you need an emergency fund now more 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 saved to cover your living expenses until you find another job? What if your company downsizes and you’re laid off without severance pay? These are actual situations that can happen to anyone.
- In case you have a medical emergency — COVID-19 is the perfect example of an unexpected medical emergency: a global pandemic that left millions of people hospitalized, unemployed, and unprepared. Even if you have health insurance, it doesn’t pay for everything.
- In case you have a family emergency — What will you do if your dog gets sick and has to go to the emergency vet? What if your child chips a tooth at recess? Credit cards are not the best option right now, with interest rates as high as they are. Even seemingly small emergencies could destroy your finances if you don’t have money saved for them.
- In case you need emergency home repairs — What if you’re hit by a hurricane or flooding? Even with insurance, you’ll have to pay out-of-pocket for home repairs, temporary living, and property replacement. Without that emergency savings fund, these costs could bankrupt you.
Read more: Were you affected by a hurricane this year? You may qualify for natural disaster tax relief
Where to stash your emergency fund
If you’ve been setting aside cash in a shoebox under your bed, pay close attention to this section.
Financial educators often suggest opening an account separate from the bank you use regularly. This keeps you from being tempted to take the money out for non-emergencies.
You also want to make sure it’s an account you can access fairly easily should an emergency arise, and where your money isn’t locked-in (for example, a certificate of deposit isn’t suitable for an emergency fund).
So, what type of account should you open?
High-yield savings account
A high-yield savings account is similar to your standard savings account. The difference is that it pays a much higher yield on your money than the national average yield on savings accounts.
A traditional savings account isn’t meant to earn money, which explains why the average interest rate for savings accounts is just 0.17%, according to the Federal Deposit Insurance Corporation (FDIC). A high-yield savings account, on the other hand, multiplies that number a dozen times, reaching rates as high as 2.70%.
However, these accounts are not the easiest to access, as they typically require you to transfer the money to a checking account to use the funds, which could cause a delay in receiving them. However, this could be a good thing because the wait could be just the deterrent you need to leave the money alone.
Read more: Best high-yield savings accounts, compared
Money market account
Money market accounts are very similar to high-yield savings accounts because they also earn a higher APY than traditional savings accounts. These accounts are easily accessible: some come with a debit card, and you can even get checks!
Just keep in mind that money market accounts allow for a limited number of withdrawals each month (like a savings account), and tend to have a higher minimum balance requirement than traditional savings accounts.
Read more: Best money market accounts, compared
Traditional bank account
This is the most common account used for emergency funds, primarily due to how accessible these accounts are.
With traditional checking and savings accounts, you won’t earn as much interest as money market or high-yield savings accounts, but you will earn some, and the convenience of them is ideal if you’re dealing with a fast-moving emergency.
Read more: Best banks of the year, compared
How to build your emergency fund
You’ll want to do a bit of budgeting to make sure you’re setting aside the right amount in your emergency fund — not too little, but not so much that you’re sacrificing other things, like paying off debts or simply enjoying life.
Here’s how to break it down:
- Decide your target savings goal. Use our emergency fund calculator to determine how much money you need to save to cover your monthly expenses for six months.
- Calculate how much you can afford to save monthly. This will require you to create a monthly budget to track your current income and expenses. Figure out where you can cut or where you have excess that you can move into an emergency fund.
- Pay yourself. Just like you pay your monthly bills, make sure you pay yourself! When payday rolls around, transfer the designated amount you set into your emergency fund account.
- Make use of windfalls. If you can’t cut your expenses any further and don’t have any excess to save, you can use “surprise” or “found” money to build your emergency fund. Typical sources of found money are tax refunds, bonuses from work, and money you receive as gifts.
- Revisit and revise. Everyone has variable monthly expenses. Review your budget regularly and make adjustments as needed. Your emergency fund will be moot if you’ve put so much into it one month that you can’t afford groceries for 30 days, or you’re forced to skip credit card payments and pay punishing interest rates.
The wrong kinds of emergency funds
There are two things that people often use in place of an emergency fund. Don’t do it. While they’ll give you the cash you need in the short term, you’ll pay out more in the long term.
Don’t use your retirement accounts and investments
Retirement accounts are the primary investment asset of most people, and for many, it’s their only source of significant savings. Consequently, you might be tempted to tap those funds in an emergency — but doing so has significant repercussions.
Pulling from your retirement savings may solve your need for cash temporarily, but it will create an additional tax liability the following year. At a minimum, you’ll need to pay ordinary income tax on the amount withdrawn. But if you’re under 59½, you may also suffer a 10% early withdrawal penalty.
Those with investment accounts may feel a similar pressure to sell stocks or funds to raise cash in an emergency. But again, you’ll face financial consequences. Either you’ll sell those investments at a loss, locking in the loss at the same time, or you’ll sell the investments at a gain, creating a capital gains tax liability.
Don’t tap credit lines
Many investment advisors tell their clients to be “fully invested.” The rationale being since returns on stocks are so much higher than fixed-income investments, keeping money in savings is a guaranteed money loser.
From a purely financial standpoint, that advice is spot on. However, many people in that situation then rely on credit lines to act as an emergency fund.
The problem with this strategy is that it simply pushes the need for cash from the present into the future. Sure, your immediate need for cash will be satisfied by the credit lines — but you’ll have to pay them back later.
Either you’ll repay the money in large lump sums or you’ll be adding a new and semi-permanent monthly payment to your budget.
The bottom line
Having an emergency fund gives you financial peace of mind. Knowing that if an emergency occurs, you have the money to cover it eliminates the economic insecurity that comes with being unprepared. Even if you have to start saving in small increments, just starting is essential.
Featured image: Sinn P. Photography/Shutterstock.com