An emergency fund is money that you have saved to deal with any financial emergencies or unexpected costs that may arise. Those can include anything that you haven't budgeted for, such as unforeseen car repairs, medical bills, unemployment or other income loss, property damage, or family emergencies. — Worldculturepost
It's also smart to plan for unexpected events with a solid strategy in addition to your emergency fund. The Federal Emergency Management Agency (FEMA) provides an "Emergency Financial First Aid Kit" to assist you with that.
Benefits of Having an Emergency Fund
Although it may seem like a trade-off, saving money in an emergency fund can offer you true peace of mind and help you cope more smoothly with otherwise stressful situations. It allows you to concentrate on solving the problem at hand without the extra worry about finances during a crisis. The sooner you begin on your emergency fund, the sooner you can enjoy these benefits.
Your emergency fund is also a way to safeguard your savings. For example, if you're saving for a home, and you have a medical emergency, you will not need to use your down payment savings to pay for the costs. Instead, you'll use your emergency fund for that. This can help you to keep moving forward with your financial goals even when you encounter the unexpected.2
It is important to create an emergency fund as soon as possible. Having one can offer you peace of mind through a crisis and make it easier to make wise financial decisions.
Here are some reasons why: An emergency fund protects you from falling into debt when you encounter a sudden financial shock. It also gives you confidence and security if you lose your income, suffer a serious illness, or need to pay for a large car or home expense. There are many advantages to building up your emergency fund. Here are eight benefits of having an emergency fund.
01. You're Working on Debt Reduction
Your emergency fund can help you avoid accumulating more debt when you face unexpected financial difficulties. An emergency fund can cover the expenses that you don't plan for, such as car maintenance or medical bills. Use your emergency fund to deal with these stressful situations and make it easier for you to concentrate on getting out of debt.
- It is easier to pay more money on debt immediately when you have a buffer for unplanned expenses.
- Include an emergency saving in your budget until it is fully stocked.
02. You're New to Budgeting
When you begin budgeting, you may be unintentionally omitting some of the expenses that you need to account for. Your emergency fund can cover some of these expenses the first year and then you can add those expenses into your budget as they occur.
This could be yearly expenses like taxes or other items like gifts or fees for organizations. Your emergency fund can assist you as you adapt to your budget.
- As unplanned expenses arise, write them down and adjust your budget to include them in the future.
- After a few months, you should not have any unforeseen expenses.
03. You Have a Single Income
If you have only one source of income, it is crucial to have a sizable emergency fund. That can help you cope with an unexpected job loss or illness that prevents the main earner from working.
If you're a one-income family or you are single, you should have at least a year’s worth of expenses in your emergency fund. You can increase your emergency fund after you get out of debt.
- If you are starting a family, you may need to boost your emergency fund.
- If you are single, work on increasing your emergency fund as fast as possible.
04. You Work as a Self-Employed or a Contractor
If you work as a self-employed, an independent contractor or if you work a job that does not allow you to claim unemployment benefits, it is important to have a solid emergency fund in place.
Additionally, if you know that your contract may expire soon, you should work on saving up more money in your emergency fund.
- You may also want to plan extra savings for months when business is slow.
- Keep track of your invoices to make sure that you do not miss outstanding payments due. This will help you avoid using your emergency fund.
05. You're a Homeowner
When you own your home, you will have to pay for all of the required repairs and maintenance. Although you should set up a sinking fund to cover remodeling and most repairs, you may have unforeseen costs like plumbing repair or air conditioning repairs.
Your emergency fund can help you manage these costs and make owning your home a little less stressful.
- Home repairs can be costly, as is replacing an air conditioner or furnace. Try setting up funds to save for these expenses before they happen.
- Be sure to plan for your taxes in your budget.
06. You're Far from Your Family
It can be costly to travel home and the costs increase if you need to travel at the last minute for an emergency. It helps to have a good emergency fund saved up to cover the cost of last-minute tickets to go home or visit other family members in the event of a medical emergency or a funeral.
- Estimate the cost of an airline ticket and other expenses, and start saving up for that.
- Remember that last-minute bookings can often be more costly.
07. You Have Health Problems
A serious health problem can cause you to max out your deductible each year. You may also have routine tests that add up quickly or need to use all of your sick leave and end up taking days off with no pay.
A well-stocked emergency fund can help you cope with these costs and make it easier to get through these difficult times.
- Health problems can be costly and insurance companies may not pay everything that you hope them to pay.
- You may also miss work and run out of sick pay, which can lead to bigger problems. Your emergency fund can help mitigate this.
08. You Have a Financial Goal
If you have a goal like buying a home or launching a business, your emergency fund can prevent you from using those savings when unexpected expenses arise. This can stop you from moving backward with these goals.
Although your progress forward may slow down a bit as you replenish your emergency fund, you will be able to preserve the money that you are saving for you. This is a great way to safeguard your savings.
- An emergency fund can help you achieve your long-term financial goals.
- Think of your emergency fund as an insurance policy against unforeseen expenses.
Creating an Emergency Fund
Before you create an emergency fund, it's a good idea to establish a savings target. The ideal target amount for your emergency fund will depend on a number of factors, including your income, expenses and bills, lifestyle, and number of dependents. If you work in a field where layoffs are frequent then it's smart to save more rather than less.
A common suggestion is to grow your emergency fund to cover at least three to six months of costs. However, if that seems overwhelming, then you can begin with a smaller, more achievable target.
You may want to set up a bare-bones budget, which lists the items you'd need to eliminate right away if you were to lose your job.
When you're ready to begin, take the time to choose the right account to store your emergency fund. You should look for an interest-earning account that lets you withdraw your money quickly if needed. This would include a money market account or a high-interest savings account.
Generally, you want to avoid storing your emergency fund in a Certificate of Deposit (CD) or Individual Retirement Account (IRA), both of which have penalties for early withdrawals.3
You can add to your emergency fund and work to reduce debt at the same time. You don't have to reduce all of your debt before creating a small fund.
Growing an Emergency Fund
Once you establish your initial savings target and set up an account, it's time to grow your emergency fund. There are different methods you can use to start doing it.
The Consumer Financial Protection Bureau provides a savings planning tool that will help you estimate how long it will take you to achieve your target based on what you can add and how often. This is a great place to start.4
To ensure you're regularly adding to your emergency fund, you can work with your financial institution to set up automatic transfers from your checking account to your savings. You can also pledge to add to your emergency fund when you receive amounts of money outside of your main income, such as gig jobs, income from hobbies and interests, gifts, bonuses, and tax returns.5
You may also want to think about using a CD ladder to increase your initial fund once you've created it. To do this, you'd open CDs with different maturity rates that match your objectives. Since CDs generally have a higher rate of return than savings accounts, then this method could help you grow your emergency fund more quickly. However, you'd need to make sure you're okay with having parts of your funds locked up for certain periods of time.6
Lately, more investment companies are creating goal-based investment strategies for their clients, including emergency funds. Betterment, Fidelity, Aghaz Investments, and Ellevest are all brands supporting goals and have set algorithms designed for emergency funds, among other goals.
If you're curious about using a CD ladder, then it's smart to consult a finance professional before doing so. It's a somewhat complex strategy that takes careful planning.
Frequently Asked Questions (FAQs)
Where is the best place to keep my emergency fund?
It can be a smart idea to save your emergency fund in a bank account that's reserved for this purpose. Don't include your emergency savings as part of your regular savings or checking accounts. In fact, some experts suggest keeping your emergency fund account at a different bank altogether to avoid the temptation of using it. Saving cash at home can be risky, because the money could be lost, stolen, or destroyed, such as in a fire—the types of events you're saving to survive.
How do I start an emergency fund?
Start with your budget and determine how much of each paycheck you can reasonably afford. Then make it a fixed habit to transfer that money to its dedicated savings account as soon as you're paid. You'll want the money you're able to save to grow for you, so consider an interest-bearing savings account with your bank or credit union. You might want to compare banks to find the one with the highest annual percentage yield (APY).
What is the 50-30-20 rule?
The 50-30-20 rule is a way of setting up your budget: 50% of your pay should go to essential needs, 30% can go to discretionary spending on things you want rather than need, and 20% should go to savings and/or reducing debt. You can adjust the percentages a little to suit your own personal goals and situations.