If you’ve had to whip out a credit card for an unexpected trip to the dentist or a sudden vet bill, you probably understand the stress of trying to figure out how to cover unforeseen expenses. Perhaps you lost your job unexpectedly, and the search for a new position is taking longer than anticipated. Having an emergency fund can greatly alleviate those financial anxieties.
Emergency funds are simple to understand, but employing a few strategies can enhance your savings and ensure you have every cent when you actually need it.
What is an emergency fund?
An emergency fund acts as a financial cushion for unforeseen costs. Typically, it is stored in an account that provides easier access than traditional investments, such as stocks or bonds, yet is less accessible than your regular checking or savings accounts.
This fund can assist you in managing urgent financial matters, like an unexpected vehicle repair or medical expense, or it can help sustain your daily expenses if you find yourself laid off, unwell, or injured and unable to earn a paycheck.
By preparing ahead and saving for emergencies, you lessen the likelihood of resorting to high-interest credit cards, withdrawing from retirement savings, or tapping into any home equity you might have built up.
How much should an emergency fund be?
The amount you should save in your emergency fund depends on your unique circumstances. If you have dependents, significant debt, or alternative sources of funds, like a partner’s income or unemployment benefits, your savings requirement may differ.
Most financial advisors suggest that an emergency fund should be sufficient to cover three to six months’ worth of expenses. However, building that from scratch can be a daunting task.
To get started, aim to save enough to cover six weeks of your typical expenses to manage most minor emergencies. While this may not be enough for every situation, it offers you some breathing space to consider your next steps more carefully.
After saving for six weeks, take a moment to reflect on whether that feels adequate or if you’d sleep better at night knowing you have more saved. Though it can be challenging to set other financial ambitions aside while you’re building this emergency reserve, it can prove invaluable if you find yourself without a paycheck.
How do you build an emergency fund?
Bear in mind that accumulating a substantial amount won’t generally happen all at once or in a straight path. Rather than feeling demoralized, consider breaking the larger objective into smaller, more achievable targets.
Begin small. Set a goal to stash away the equivalent of one paycheck in your emergency fund. Depending on your budget flexibility, this might take several months. Focus on the long-term advantages and contribute however much you’re able, even if it’s only $20 per month.
Calculate expenses to decide how much your emergency fund should be
Start by determining how much you should aim to save. Assess the minimum amount you spend each month on essential expenses such as:
- Housing
- Food
- Utilities
- Insurance (health, auto, etc.)
- Transportation
- Prescription medications
- Debt repayment
- Child care (if relevant)
- Other essentials when you need to cut back significantly
Since we’re focusing solely on essential expenses, you don’t need to consider costs like entertainment, dining out, or savings for future goals like a down payment on a home or a vacation fund. While it’s important to save for these objectives under usual conditions, during a severe emergency, you might need to pause contributions to those funds or tap into them for immediate costs.
Once you determine the amount necessary for your emergency fund, create a plan to achieve it. Divide your total goal into a monthly saving strategy and set up automatic transfers from your paycheck to help you save without overthinking it.
Where should I keep my emergency fund?
When choosing where to maintain your safety net, consider what level of access you need to your funds. Here are three factors to take into account:
Is the account federally protected?
It may be tempting to place your emergency fund in the stock market for potential higher returns. This is not advisable. While the stock market can potentially yield greater returns, it also carries a heightened risk of loss.
Instead, store your savings in a bank or money market account (not to be confused with a money market fund, which is an investment type) that is insured by the FDIC, or in a credit union that is federally insured by the NCUA. These protections mean your funds are federally safeguarded up to $250,000 for each depositor.
Is the account accessible?
While you want to ensure your funds are accessible, they shouldn’t be too easily obtainable. Otherwise, spontaneous purchases like concert tickets, gadgets, or unplanned travel may quickly erode your hard-earned savings. It’s wise to keep your emergency fund in a separate bank from your everyday checking and savings accounts. This can help prevent impulsive buying while still having your cash readily available when necessary.
It’s advisable to maintain your emergency funds in a bank rather than depending on collectibles or real estate, which would not typically serve well as emergency resources. Although alternative investments may interest you, those shouldn’t be treated as an emergency fund.
Should you use a high-yield savings account?
Even though your emergency fund needs to be secure and easily accessible, it’s also important to earn the highest interest rate possible. Look into high-yield savings accounts to grow your funds effectively.
You might discover that online banks frequently offer higher interest rates compared to traditional banks. Make sure to research thoroughly to verify that the bank is FDIC-insured, understand any associated fees or minimum balance requirements, and ensure it can link to your primary checking account for hassle-free transfers.
Should I save or invest?
In an ideal setting, you would have enough budget flexibility to both save and invest at the same time. However, since that isn’t always realistic, you may need to prioritize your goals.
For some individuals, the main focus is saving for retirement, and they have other strategies to navigate temporary financial challenges or are comfortable using a credit card for unexpected costs.
Others might prioritize remaining debt-free and consider contributing to an employer-sponsored 401(k) sufficient until their emergency fund is fully established. Ultimately, once you achieve your emergency savings goal, you can allocate those funds to different purposes like investing or retirement savings.
You could also craft a mixed approach, dividing your savings toward both ends. While it might extend the time needed to accomplish each goal, you’ll still be making gradual progress on both fronts.
There is no universally correct answer; just the option that best aligns with your circumstances. The key is to create a strategy that suits your life and needs. Don’t postpone starting your savings or investment journey; take those initial small steps today.
Bottom line
An emergency fund can enhance your financial resilience and help you steer clear of accumulating debt or increasing your current liabilities.
Consider how much money in savings would provide you with peace of mind and work towards that target. Progress may require a slow approach with just a few extra dollars each month, but concentrate on making strides rather than achieving perfection. Save what you can, and remember that each dollar you manage to save today can protect you from debt down the line.
