Among the four pillars of financial wellness – saving, spending, investing, and protecting – saving might be the most foundational. You most likely have heard from personal finance gurus and financial literacy blogs about the importance of an emergency fund. But you might also be scratching your head as to why you need an emergency fund.
Wonder no longer. An emergency fund is to protect you from the danger of falling into debt. Some may think that paying off existing debt is the most pressing item on a financial to-do list. However, without establishing a savings cushion for unforeseen emergencies, you might inadvertently spiral even deeper into debt.
In this guide, we'll go over the particulars of an emergency fund, why you should have one, and how to start building one.
What is an emergency fund?
An emergency fund is savings you've put aside for unexpected expenses or shifts that lead to a financial shortfall — think pricey car repairs, urgent dental work, or if you've been laid off or have had your hours scaled back at your job. You can set aside this pile of cash in a savings account.
An emergency fund is different from a rainy day fund, which is typically a buffer that you have sitting in your savings that you can tap into for one-time, minor, unexpected expenses. Money in a rainy day fund can also be used if you're having a lean month and need a small influx of cash to tide you over until the next paycheck.
Why you should have an emergency fund
There are several reasons why you should have an emergency fund. First, it prevents you from needing to borrow or reach for your credit card. While borrowing or putting purchases on your credit card is a short-term fix, it can cost you significant interest and fees.
And if you already have existing debt and have been making efforts to pay off the balances, an emergency fund provides a buffer so that you won't have to dig a deeper debt hole. Otherwise, should life throw you a curveball, you might need to add more to your debt pile.
An emergency fund can also provide peace of mind and ease feelings of stress and anxiety. That's because not having enough in your emergency savings can be a major source of financial stress and impact your overall mental health.
How much should you have in your emergency fund?
The golden rule is to squirrel away at least three to six months of your basic living expenses for an emergency. That way, should a major life-shifting event set you back financially, such as a job loss, you'll have enough to cover your bills.
How much you should have also depends on your situation. For instance, if you're part of the gig economy, freelance, or are self-employed, it's best to have more than six months, which is anywhere from six to 12 months of basic living expenses is ideal.
It also boils down to what you're comfortable with. Some folks might get anxious about not having enough aside for unexpected expenses and prefer to have more than the recommended amount.
Plus, there's also a downside of having too much saved. If you have "too much" sitting in a savings account for emergencies, that's money that might be better off in an account that yields higher interest rates or put toward investing. That's money that could be working for you and growing more quickly.
How to build an emergency fund
The recommended three to six months of basic living expenses might seem like a tall order, especially if you're struggling to make ends meet, have debts to pay off and juggle different financial obligations and commitments. That being said, there are simple ways you can start building your emergency fund.
Start small
Commit by setting smaller milestones. For instance, if three months' living expenses are $2,000, and you'd ideally like a grand sum of $6,000 to $12,000 for your emergency fund, make a pact with yourself to save $250. Then, bump it up to $500, then $750, and so forth.
Find ways to save more
Look for ways you can bump down expenses. Pore through your bills and see if you can negotiate any recurring expenses so you pay less each month. Aim to save on groceries by buying what's on sale and eating out less.
Here's the trick: every intentional act of saving should go straight into your emergency fund. For instance, if you call your cell phone provider and save $20 monthly, put that directly toward your emergency. If you decide to cook dinner instead of ordering takeout, transfer that $15 savings into your fund.
Look for ways to earn more
On the flip side, drum up ways you can make extra money. For instance, ask your current employer if there are any opportunities for you to work extra hours and rake up some overtime. Or take on a side hustle if your time and availability permits.
Automate your savings plan
Setting up automatic savings is a simple, one-time deal. And it's like having someone else do the work for you. The same rule of starting small applies. You don't need to save a considerable amount. See if you can autosave $5 or $10 a week. $10 a week adds up to $520. Or you can do the 52-week savings challenge. This one-year challenge starts with $1 the first week, $2 the second week, and so forth. By Week 52, you would've set aside $1,378 toward your emergency savings.
Where should you keep your emergency fund?
Ideally, you should keep the money saved for your emergency fund in a savings account. There are several benefits of owning your emergency fund in a savings account instead of a checking account.
For one, that money is tucked away in a separate account other than your checking, which is used for everyday expenses. That way, you can monitor your progress and not accidentally spend money for emergencies. Another perk of a savings account is that they usually have higher interest rates than a checking account. In turn, you can earn a little more on interest, and your money can grow.
If you have a savings account in a separate account from your primary checking account, consider putting your emergency fund there. That's to prevent temptation from impulsively taking money that should be spent solely for unexpected, urgent expenses.
It's best not to keep your emergency fund in a certificate of deposit (CD). That's because if you're in a financial pinch and need to pull money from your savings account sooner than later, you'll get hit with an early withdrawal penalty.
If you happen to get to a place where you have more than the recommended six months of emergency funds tucked away, you might want to consider putting that money in a CD, which might earn more in interest than a standard savings account.
As for putting your savings in a taxable investment account, your money is subject to volatility and could lose value by being in the stock market.
An emergency fund is an essential part of staying financially healthy. By knowing how much you would need to save, starting small, and stashing your funds in a separate account, you can be well on your way to covering those one-off, unexpected expenses.
