How to Build an Emergency Fund
It’s hard to build a case against having some cash on the side. In personal finance, this is known as an emergency fund (or a rainy day fund) for unexpected expenses. In essence, the idea is to have enough money so that you can weather a crisis. We are talking about instances like losing a job or servicing a car breakdown; also urgent travel, and any similar crisis that creates unplanned expenses.
Do you need an emergency fund?
I would say it’s better to have it and not need it than the other way around. Life is unpredictable – regardless of how comfortable you are with where you’re at, unforeseen events can quickly turn all that around. No one is off-limits, however, having emergency savings can ease the transitional period that may arise after a negative and unexpected turn of events in your life.
If you have a look around, emergency funds are not very popular. In fact, a large portion of Americans (almost 40%) would rather go into debt through credit cards or borrow from friends than prepare for the unexpected in advance by saving. This doesn’t really paint the picture of a population that is on top of their personal finances. And if the COVID-19 crisis taught us anything, it’s that you can’t take economic prosperity for granted.
Join us as we examine the circumstances that determine the size of your emergency fund, and provide some budgeting tips on setting aside some money for a rainy day. We will also consider the type of financial accounts that allow you to create an emergency stash and show you how you can incorporate emergency savings into your overall financial goals.
How much should your emergency fund weigh?
Common wisdom says that you should set aside from three to six months’ worth of expenses. The premise is that you want to be ready for going through this period without any income if you have to. Now, since the average monthly expenses in America are around $5,000, the numbers quickly add up ($30,000 for six months). Figures in the tens of thousands (and the thought of saving such amounts) might discourage you, so it’s best to make your own assessment as to the actual size of the emergency fund. Let’s take a closer look.
How much do you spend in a month?
Your emergency savings should be tailored to your needs because average figures won’t get you anywhere. Close inspection of your monthly budget will quickly allow you to hone in on a specific amount. If you don’t have an idea about your monthly spending (which you should!) you can track your expenses starting today.
Bear in mind that we are considering minimum amounts that would keep you going. So, the cost of housing, transportation, groceries, utilities, gas, and so on. If you remove non-essential expenses (wants but not needs) and multiply the figure by 3 or 6, then you will get a more conservative (lower) amount.
Life circumstances
This is where emergency fund planning becomes a thought exercise. Performing an analysis of all income streams in a household can narrow down the goals of emergency saving. Things like the number of dependents (kids, or ailing parents), as well as the number of household members who can bring in income have to be factored in. And take it one step further – what type of income is that?
For example, married couples (or households where two members bring money) can reduce emergency funds to 3 months worth of expenses, especially if the likelihood of both income streams being lost at the same time is low.
Also, don’t think that you would need less money in your fund just because you live by yourself. It’s quite the opposite, especially if you don’t have someone (family or friends) you can lean on financially in case of trouble.
One last thing before we leave this grim outlook on the future: you have to consider the worst-case scenario in terms of possible consequences. What is your fallback plan if you suddenly lose all of your finances? For example, some young adults have the option to move back in with their parents. Or those in advanced age can join their children’s family in a grandma annex to the house.
Also, those that have something of value that can be sold don’t need a large emergency fund. Be mindful that assets like real estate and bonds don’t count because they aren’t liquid; rather, think of something others would be willing to buy on short notice.
All these factors can play a significant role in determining the actual size of your emergency fund.
Emergency fund budgeting
What is the usual distribution of income through your budget? You will need to slightly tweak it in order to satisfy emergency saving goals. And don’t sweat it if this is your first conscious “saving” effort, it’s easy to establish sound budgeting habits if you have the right resolve.
Cut expenses
We’ve all heard this one before: “It’s easy to save if you cut costs”. In reality, executing a savings plan takes a lot of willpower and fiscal discipline. The main issue is how to let go of the perks we’re accustomed to. Cutting down expenses translates into driving a less expensive car, skipping a vacation, downgrading a subscription service (cell phone, TV, magazines), or minimizing dining out and alcohol consumption.
Admittedly, none of these voluntary restrictions comes easy. And we didn’t even touch destructive lifestyle habits like cigarettes, gambling, or substance abuse. So every bit of motivation helps.
Track your savings
No one expects you to save $30,000 in two months, so don’t be hard on yourself. These kinds of financial goals are achieved by incremental steps and you can set up benchmarks or mark milestones to keep your incentive levels high. For example, some people set their first $1,000 in the emergency fund as an immediate goal, or the moment when they’ve saved one month’s worth of living expenses, as a milestone.
When you are setting money aside, every little bit counts. These days, you can also put software in service of budgeting an emergency fund. Setting up automatic deposits that go straight into your emergency savings account will help streamline the process. And if you are not a great fan of automation, you can try to compartmentalize your budget and consider your emergency fund as a debt to another entity. This is also known as the “pay yourself first” approach and it definitely works in creating a mental rationale for some folks.
Don’t spend free money
We know there is no such thing as “free” money (unless you believe that money grows on trees). What we’re referring to here is more like tax refunds, raises in wage, stimulus checks, and similar increases in your regular earnings. Paying off a big loan is another example of this, because it suddenly leaves you with a little bit of extra cash. What did you do with your last unexpected drop of cash?
When emergency fund budgeting is concerned, it’s very important to master the art of living within your means. Some would even argue that you ought to live below your means if you want to achieve certain financial goals faster. Ultimately, it’s up to you how you’ll spend your money. If you do have to maintain a level of spending, at least consider setting up a model of budgeting by percentages.
Increase your income
What do you do when you need money under regular circumstances? You earn some greens – so the same principle applies when you are after extra money. It can be a second job, a side freelance project, an occasional gig, or something along those lines. This aspect of budgeting can vary significantly for each of us because these days, there are so many ways people can use their hobbies, interest, skills, and talents (especially digitally) to add an alternative income stream. It can be of great help, even if it’s irregular.
Where should you pile up emergency funds?
Since the central goal here is to have your savings both secure and accessible, you should opt for a solution that satisfies such requirements. A note to investors out there: emergency funds should be designed as a liquid asset. While it’s great if you can tie up your capital in bonds, stocks, and real estate to achieve investment goals, this will not do you any favors when you are faced with unplanned expenses. These types of assets are either unavailable or pulling them from the market can potentially hurt your investment (for example, there are penalties for cashing in on bonds before maturity).
At the same time, big spenders should devise a plan to keep their hands off the emergency jar, because the temptation to do so will be looming. To mitigate the risk of succumbing to their own bad habits, some decide to open a savings account in a different bank than the one they use for checking accounts. This allegedly helps not to abuse the emergency fund.
Depositing money
Speaking of which, bank accounts are considered the best option for keeping emergency funds, mostly because in this manner, the money will accumulate interest while at the same time ensuring ease of access. Not all accounts offer the same characteristics though, so let’s run through several options.
Bank (or credit union) Account
Opening a new savings account at the same institution that already handles your checking account is very easy to set up. The argument here is that having both accounts in the same bank (or credit union) will help you avoid high transfer fees. And of course, you accrue interest.
High-yield savings account
These are the accounts that are the closest to being tailored to serve as emergency funds. They offer the highest interest rates (up to 0.70%) in relative terms. However, it should be noted that high-yield savings accounts in online banks sometimes aren’t available on short notice.
Certificate of deposit (CD)
The purpose of Certificates of Deposit is to invest by lending money to a bank and collecting interest. However, the interest itself is paid based on an agreement that the money will stay in the bank for a prolonged period of time (from months to 10 years). So, if you put your emergency savings in a CD, look for one with low penalties for early withdrawal.
There are two other alternatives that are also very popular. Money market accounts have grown in prominence because they also offer high-yield interest, but a minimum amount in the thousands (starting from $2,500) is a prerequisite to opening one. Also, as we mentioned earlier, retirement accounts can double as emergency funds. Some choose Roth Individual Retirement Account (IRA) to fulfill this role by accepting potentially high withdrawing costs down the line.
Utilizing emergency funds
As soon as you start building your emergency fund, it’s pivotal to clearly define what constitutes an emergency, i.e when are these funds to be used. Every adult with access to the fund should have an understanding and be on the same page. And, yes, it’s best if more than one adult can manage the fund because we are discussing unexpected needs here, and that includes instances when, for whatever reason, the account holder is incapacitated.
Failing to set guidelines for using the fund is a recipe for disaster – instead of providing much-needed relief, it can lead to additional conflicts and stress.
Emergency funds vs your other financial goals
Now, quite naturally, those who want to exercise control over their personal finances and commit to long-term financial planning view emergency savings from a different perspective. There’s one question that’s probably at the top of their minds: “Which financial goal should be the biggest priority: an emergency fund, paying off a debt, or saving for retirement?”
The dilemma is legitimate and warrants some thought, so let’s get into it.
Emergencies and accumulated debt
The level of consumer debt in the US can’t be ignored. Notwithstanding the reasons, many Americans are not only faced with settling outstanding debts but also have to deal with creating and managing an emergency fund. Obviously, this can be overwhelming at times.
Generally speaking, it’s recommended to save at least one month’s worth of living expenses before you go after long-term financial goals. If you have a high-interest revolving debt (credit card) this might seem hard to pull off. However, keep in mind that tackling debts without near-term thinking will only force you into new debt once the old scores are settled.
The step-by-step plans depend on your unique circumstances, but putting your debt consolidation strategies in practice will be way easier if you have already started building an emergency fund.
Emergency funds and saving for retirement
Retirement savings are a lifelong endeavor, so what we shared about pursuing long-term financial goals above applies to investing as well. Retirement accounts can offer flexibility and you can even use them to double as an emergency fund, at least to a degree. After you have secured an amount for immediate expenses (one month) in your emergency savings, you can then turn to growing your retirement account. In times of need, certain retirement plans, like 401(k), can be used to get a line of credit, practically from yourself. If you have this option, you can also take a less aggressive approach toward emergency fund building.
There is no reason to sacrifice one financial goal on account of others; prudent management of your personal finances should allow you to tackle all three.
In closing
Everyone of legal age should have a stash of cash that can be used on short notice. There are all sorts of instances in which this money can be used (i.e emergencies), but nevertheless, having such funds is a necessity.
The amount of money in the emergency fund and the place where you store them depend on your unique circumstances. This fund, along with debt repayment, retirement funds, and investments is a critical requirement on your road to financial freedom.
