Life is full of surprises. Sometimes we get lucky and hit the lottery. Other times we have bad luck: we lose our job, we get into an accident or our home is damaged. When bad luck happens, it often gets expensive quickly. That’s why it’s a good idea to have an emergency fund.
If you don’t have an emergency fund, never fear. We’ll explain what an emergency fund is, when and how to use it and how to build one.
What Is an Emergency Fund?
An emergency fund is a dedicated savings account that you keep in reserve for emergencies.
It shouldn’t be used for everyday purchases or to fund large purchases, like the down payment on a home or car. Instead, it should be a “rainy day fund” for unexpected problems like losing a job, a medical emergency or unforeseen damage to your home or car.
Also, an emergency fund shouldn’t be used once and then ignored. It needs to be replenished as soon as possible after it’s been used and grown like any other investment.
Why Do You Need an Emergency Savings Fund?
Having an emergency fund isn’t just about being prepared for the unexpected. It’s about building a safety net to keep you out of debt and honor your financial obligations.
Staying out of debt
When big, unexpected events happen and you don’t have an emergency fund, your first instinct might be to reach for your credit card.
A credit card can help you pay for those unexpected expenses. But now you’re carrying a balance on your credit card. And that balance is subject to an annual percentage rate of 12% – 25%. How much will that cost you?
Let’s say you need to pay $3,000 in auto repair costs and put it on a credit card with an 18% interest rate. If you were to pay $200 a month to pay off that balance, it would take 18 months and cost you $424 in interest.
And that’s assuming that you’re not already carrying a balance on the card and there are no annual fees that you need to cover.
Meanwhile, having a balance on your credit card can lower your credit score. That can make it harder to borrow money in the future.
Meeting your financial obligations
An emergency fund is critical if a significant portion of your income is currently going to cover your mortgage and home expenses, making you house poor. It’s just as necessary if you’re juggling a lot of debt from credit cards, student loans and personal loans.
Having an emergency fund means having the money to stay on top of your expenses, even if your cash flow is disrupted. In short, you have the money you need when you need it. That saves you from having to pay extra interest and helps you keep your credit in good shape.
When Should You Use Your Emergency Fund?
Like insurance, an emergency fund is something you’ll be glad to have but hope you’ll never have to use. However, it’s important to set limits for when you allow yourself to use your emergency fund. Usually, the money should only be used for serious emergencies, including:
Job loss or loss of income
Even if you are eligible for unemployment or get a severance package from your former employer, it can take time to find a new job and get your first paycheck. Having money in reserve to cover expenses like the rent or mortgage, and to keep up with your other payments, can give you peace of mind until you can get back on your feet.
Whether it’s kids breaking a window with a baseball, a leaking roof, a broken furnace or everyday wear and tear, things in your home will break over time. And your homeowners insurance won’t always cover the cost of repairs or may come with a high deductible. Having the funds available to cover the cost of unexpected repairs means that you can make your home liveable in less time and with less stress.
If you own a car, it’s hard to imagine life without it. But an accident or unexpected breakdown can quickly add up to thousands in car repair costs. Even with good auto insurance coverage, you’ll probably need to pay a deductible of $500 – $1,000 or more. And if your repairs aren’t covered, you may find that you’ll need to finance the repairs yourself.
Unexpected medical expenses
Health care in the U.S. is expensive. Without health insurance, a broken leg can cost up to $7,500, a 3-day hospital stay can cost $30,000 and long-term cancer treatments can cost hundreds of thousands of dollars.
Hopefully, you have some kind of coverage to help offset medical bills, but even then, a sudden illness or injury can quickly get expensive. And if the injury or illness causes you to miss work or lose income, that can make a bad situation worse.
If you have a pet, you know how much veterinary care can cost. While pet insurance is available, setting aside money for furry friend expenses is also a smart move.
How Much Should You Save?
Most experts recommend that your emergency fund has enough money to cover around 6 months of monthly expenses.
In some ways, the better off you are, the less you may need for an emergency fund.
If you have good insurance coverage and you’re financially stable, you may feel that you only need $1,000 a month to cover deductible expenses.
On the other hand, if your income fluctuates throughout the year or you’re less insured than you’d like to be, you’ll probably want to put as much as you can into your emergency fund so you’ll be ready.
Where Should You Keep Your Emergency Savings?
Ideally, you should keep your emergency funds separate from the checking and savings accounts that you use for your everyday expenses. You want to put your money in a fund that you can access quickly. At the same time, since you’re not using it every day, you might as well put it into account that provides a good return on your investment.
High-yield savings or money market account
A high-yield savings or money market account can provide you with a higher interest rate than a standard savings account while still providing access to your funds.
For both of these accounts, it’s important to know that there may be a minimum balance that you need to maintain, and you may have limited monthly withdrawals. Otherwise, you may get hit with additional fees that can quickly add up and even hurt your credit.
Alternatives to emergency funds
While nothing beats cold hard cash in an easy-to-access savings account, there are other ways to set money aside or have funds available in a pinch. These options can offer a better yield than a standard savings account – or at least a lower interest rate than a personal loan or credit card – but may also come with added costs, complications or risks.
Certificate of deposit (CD)
While a CD offers better interest rates, they usually require you to keep your money in the account for a fixed amount of time. Otherwise, you may have to pay extra fees.
IRAs, Roth IRAs, Annuities and Investment accounts
Investment accounts can grow your money faster than a savings account, but if you need to withdraw money, you may be charged fees and tax penalties that can cost you. Also, if your investments take a downturn, you risk losing money if you withdraw too soon.
Home equity line of credit (HELOC)
If you have enough equity in your home, you could take out a HELOC when you need money in a pinch. A HELOC lets you access your available equity when and if you need it. While you’d need to pay interest on any money you withdraw, HELOC interest rates are usually much lower than credit card or personal loan rates.
A HELOC usually has a limited draw period of 5 – 10 years. After that, you wouldn’t be able to access your money. You would enter the repayment period and have to pay off the remaining balance.
What Steps Should You Take To Build an Emergency Savings?
So now that you know why you need an emergency fund, you may be wondering how to build one. It won’t happen overnight, but with a little planning, you can build a 6-month emergency fund in less time than you think. Here’s how:
Budget for your lifestyle
As previously mentioned, you should aim to have enough in your emergency fund to cover 6 months of expenses. But what does that entail? Ideally, you should set aside enough money to cover:
- Your mortgage or rent payment
- Utilities, phone and other fixed monthly expenses
- Insurance payments, including health, life, home and auto
- Transportation costs, including gas and tolls or rapid transit expenses
- Any auto loan, student loan or personal loan payments
- Monthly minimum payments on your credit cards
- Groceries and other necessary living expenses
Beyond that, look at your current spending habits and try to determine if there are any other expenses that you’ll want to cover if the worst should happen.
Total it up and make that your goal for your emergency fund.
Make saving your new habit
Want to start building an emergency fund? Set goals for yourself and figure out how to reach them. Let’s say your monthly expenses are $1,200, and within a year, you want to have enough in your emergency fund to cover one month.
You can do it. Simply add $100 a month to your emergency fund.
Try setting aside a certain amount each month or each payday before you pay any other bills. You’d be surprised how quickly it can add up.
Set up your savings for autopilot
The hardest thing about saving money is remembering to do it. Using an automatic transfer or direct deposit through your bank is an easy way to save money with minimal effort. Want to save $100 a month? It can be as easy as setting up a $25 transfer every week.
Getting a bonus at work, a gift from family or friends or did you luck into an unexpected windfall? Maybe you got a decent income tax refund this year. Before you spend it on yourself, try transferring all or some of the money to your emergency fund.
For example, let’s say you found some old bonds from a grandparent. They’ve matured and you can cash them out for $1,000. One thousand dollars isn’t necessarily enough for an emergency fund, but it can be a good start. It may cover a deductible or lay a foundation for a bigger fund.
Don’t stop saving when you hit your goal
You’ve been saving consistently. And you’ve hit your goal of 6 months’ worth of expenses in your emergency fund. Congrats, but don’t stop. If you have the money to spare, try to build enough to cover your expenses for an entire year.
Already hit that goal? Take the extra money and invest it in a 1-year certificate of deposit or add it to your IRA or other retirement accounts. The money will earn more in interest, and if you still need it for an emergency, there are ways to tap into it later on.
How Can You Use Your Emergency Fund Responsibly?
The key to using your emergency fund responsibly is to only use it for emergencies. That can be harder than it sounds. When you’re looking to save money for a vacation or new clothes for the kids, or even when money is tight, it’s tempting to dip into your emergency fund.
But don’t. Instead, try to set aside a separate savings account for special purchases or look into other ways to finance your special purchases.
Remember, an emergency fund is designed to protect you in the event of an emergency. You don’t want to be caught with less when you need it.
Emergency Savings Is an Investment in Yourself
Setting up an emergency fund may seem like a hassle. After all, aren’t there other ways you could use that money? But when things go sideways, having an emergency fund can be a real lifesaver. Best of all, if you’re super lucky and never need to access the fund. The money will be there, growing interest for the future.