Everyone should have an emergency fund. But many people don’t. Learn how to build one — before you need it.
Many Americans live from paycheck to paycheck. It’s a recipe for financial hardship. Unexpected events like a loss of income or emergency expenses can easily upend your financial stability.
An emergency fund can get you through short-term financial challenges. It can be the difference in preventing a dire long-term financial situation.
What Is an Emergency Fund?
Setting money aside to cover unplanned expenses or circumstances such as a sudden job loss is making an emergency fund. It’s a safety net that provides for essential expenses or large, unexpected bills.
What Are Emergency Funds For?
An emergency fund can go toward any number of things. A common one is medical bills following an accident or illness. Another is an expensive, unexpected expense like home repairs, car repairs, or a major appliance replacement. If you’ve lost a job, your emergency fund can cover rent or mortgage as you seek a new job. It can also cover monthly expenses like utilities.
Why Do I Need It?
These emergency savings help you meet financial obligations without draining your regular sources of income. They help you keep your personal finances sound as you get through unexpected expenses or a temporary financial crisis. Without one, many people use their credit cards, which can get them into debt that builds due to accruing interest.
How Much Do I Need in It?
For an emergency fund, more is better. As a general rule of thumb, it should have a minimum of 3-6 months’ worth of living expenses. Alternatively, it should cover your insurance deductibles. If possible, grow it through steady deposits to where it can cover both.
Where Should I Keep It?
Some people use an individual retirement account (IRA) as an emergency fund. There are some drawbacks to that. First, that money is supposed to be for retirement. Second, you’ll either have to pay it back, with interest, or incur fees and have a smaller balance.
Another temptation is to use one’s regular savings or checking account. One problem with that is that it’s easy to dip into it without needing to. Another reason is that these accounts typically pay little or no interest. It’s better to put it where it can grow but where you can make a penalty-fee withdrawal when needed.
Here Are Some Options for That:
- A money market account: These don’t return as much as investing can, but they’re more stable. Many banks offer debit cards and/or checks with money market accounts. Some hit you with penalties if you don’t keep a minimum balance.
- High-yield savings accounts: The higher interest rates these offer over regular savings accounts make your money grow faster.
- Certificates of deposit: Also known as CDs, these earn interest on a lump sum over a fixed period of time. Early withdrawals can result in lost interest or penalties (fees).
If possible, find options that offer compound interest. This results in a higher annual percentage yield (APY). When considering any financial institution, look for a (Member FDIC) logo. This means the institution is backed by the Federal Deposit Insurance Corporation. The FDIC is not the same as the Federal Reserve. Congress created the FDIC to insure depositors to U.S. banks. Currently, the FDIC insures up to $250,000 per depositor per insured bank.
To compare banks, take advantage of Bankrate.com. The annual Bankrate Survey gathers the APRs and APYs available so you can make direct comparisons. This includes banking deposits, loans, and mortgages. Also, try to avoid any institution that charges a monthly fee unless the return is truly exceptional.
When Should I Use It?
As the name implies, you should only use your emergency fund for emergencies. These are major expenses that could otherwise blow a hole in your budget and land you in debt. They are also times when you lose a job and haven’t secured a new one yet. Basically, use your emergency fund when you don’t have the money to meet your expenses without going into debt.
Expensive vacations are not financial emergencies. Deciding to live a lavish lifestyle isn’t one.
How To Create an Emergency Fund
So how do you create an emergency fund? There are four basic steps.
Increase Your Income
If you earn more money, you can put a higher portion of your paycheck into your emergency fund. But it isn’t always easy to go out and find a better-paying job. Other options to increase income are side gigs, selling unwanted and unused items, living more frugally, etc.
Sometimes, income boosts can come from unexpected places. Windfalls like inheritance and a higher-than-expected tax return are ways to add to an emergency fund. So is a work bonus you hadn’t been expecting, or a generous raise.
Decrease Your Expenses
Lowering your expenses can free up money to add to an emergency fund. Ways to do this include efficient energy use, reducing entertainment costs, skipping convenience stops, and more. Just dining out less often and cooking at home more can save a lot of money.
Automate Your Savings
With an automated transfer like direct deposit, your pay goes directly to your primary account. You can do something similar when building an emergency fund. For example, you can designate an amount of money to transfer from your main account to another each month. By doing so, you don’t have to worry about forgetting.
Make a Budget
Create a budget that lists and tracks all income and expenses. With a calculator, figure out how much you can dedicate to your emergency fund each month. Once you develop and maintain a budget, you can plan financial goals, including a savings goal. Budgets also let you see places where more money than necessary is going. Then you can make adjustments.
With an emergency fund, you can cover yourself for months of expenses while staying financially solvent. If a crisis occurs, you’ll be better equipped to handle it because you’ll have a fallback plan. That’ll keep you from defaulting on payments, running up credit card debt, and other inadvisable practices. Staying out of financial trouble helps you lead the lifestyle you want and work towards your goals.