Benefits of an Emergency Fund: Why They Matter and How to Build Yours
October 12, 2018
Most people know you need an emergency fund, but you may not know how to make it happen. “Extra” money can be hard to come by; and when you do find a little extra in your budget (or under the couch cushion), one of the hardest things to do is to set it aside in case you need it later. This is especially difficult if you’re struggling to make ends meet or have high levels of debt, but these financial backstops could be a lifesaver in times of need.
Setting aside funds in case you need them later is one of the smartest things you can do with your money. An emergency fund can help during a catastrophe, which could be anything from a plumbing disaster to unemployment. In fact, when something unexpected happens, you can’t afford not to have an emergency fund.
We’ll discuss why you need an emergency fund, how to build one, and other information to help you prepare for an unexpected financial crisis.
Why you need an emergency fund
An emergency fund is money you set aside to use for unexpected expenses. It’s important to have money saved up so that you don’t have to borrow cash or use your credit card to cover an expense you hadn’t planned for. Surprisingly, 55 million Americans have nothing saved for such an expense and 40 percent don’t have enough saved to cover an expense of $400, according to a 2018 Federal Reserve report.
An emergency fund gives you the ability to cover routine expenses, have some money left over, and decrease your level of financial stress.
Emergency or “rainy day funds” are an important piece of the financial stability puzzle. Depending on your financial situation and goals, it may mean having enough to make it through a month and pay all the bills, with something set aside for a few unplanned expenses; the ability to simply save a certain amount each month; or being able to send your kids to college, take a vacation, and feel confident about your lifelong financial security.
The common thread is the ability to cover routine expenses and have some money left over, while decreasing your level of financial stress. Financial stress is linked to health problems, including depression, heart issues, anxiety, and lack of sleep. Relationships with family and friends can suffer when you are feeling the effects of financial stress.
How to build your emergency fund
Rome wasn’t built in a day, and your emergency fund won’t be, either. Start small and work your way up.
- Always pay your essential bills first. Adding to your emergency fund is important. However, if you lose your home in an emergency, you’ll be stuck with no income, no residence, possibly no equity- and all of your old bills.
- Reduce debt. The more you do to reduce debt, the more easily you will be able to save. You may be able to do some major belt-tightening to accelerate your debt payoff, but you should consider all of your debt relief options if you need help.
- Don’t neglect retirement savings. It’s smart to build an emergency fund before you contribute to retirement savings. However, if you work for an employer with a matching program, not participating is like giving money away.
- Treat savings as a bill. Make your emergency fund part of your budget, and treat that monthly savings goal as a bill you must pay. If you can set aside $25 a week, you’ll save $100 by the end of the month and more than $1,000 each year.
- Automate your savings. You will be less likely to miss money that you don’t see. Look into setting up an automatic transfer from your primary checking account to your emergency savings account each month.
- Save your windfalls. It’s a good feeling to pay off a car loan, get a tax refund, or even see proceeds from a garage sale. Make a commitment that when one of these things happens, you’ll put the money in your emergency fund instead of spending it.
- Find savings—at home, at work, at the store. With a little creativity, you can find many ways to trim your spending, such as skipping the coffee shop and being careful with online subscription services. Direct the savings you get to your emergency fund.
- Generate extra income. Many people earn money for their emergency funds by selling unneeded items on online sites like eBay and Craigslist or at a yard sale. You also may be able to handle a part- time job.
How much should you save in your emergency fund?
Your emergency fund amount will depend on your unique situation. Conventional wisdom says that it is a good idea to save six to nine months of basic living expenses in this fund. If you have an unexpected event that affects your income, that level of savings helps to sustain you until you can get your feet on the ground again.
If saving six to nine months of living expenses sounds daunting, the key is to begin saving toward the level of expense that causes you to rush to a credit card. Is it a car repair bill for $500? A medical bill for $750? Save until you have at least that amount available, and then keep building toward the goal of six to nine months of basic living expenses.
Also, remember that having enough for basic living expenses means having enough money to pay the necessities: rent or mortgage, car payment, insurance, utilities, and groceries. In an emergency, you don’t spend money on vacations, expensive new clothes, dining out, or other luxuries.
Where to keep your emergency fund
Since emergencies happen unexpectedly, it’s vital that your emergency fund be easily accessible (within one or two business days)—but not so accessible that you’ll be tempted to tap it when there isn’t an emergency. Consider a traditional savings account or money market account, one that is separate from your main account. Both types of accounts allow you to earn some interest while you save.
After your savings have grown to a more sizable amount, you might think about investing part of the funds in something that pays better interest, like a bond or a short-term certificate of deposit. But remember: it’s important not to take too much risk with these funds, and quick access to your funds is essential.
When to use your emergency fund
When to dip into your emergency fund will depend on your individual situation. The right time is usually when an unforeseen event occurs that would cause you to turn to a credit card and carry a balance, versus paying off the expense in full and on time at the end of the month.
Recurring (annual, quarterly, semi-annual) expenses should not fall into this category. You know that the auto insurance bill, for instance, comes twice a year. You know when holidays and birthdays occur. For these expenses, you must save a bit each month so you’re ready when they come up. A monthly or annual budget will help you plan for these expenses.
Also consider the timing of your intended purchase. If the furnace goes out mid-winter, and you live in a cold-weather state, you likely will need to replace it immediately. Using emergency fund savings to do so may be necessary. On the other hand, if there’s a great sale on the new washer and dryer you’ve been eyeing, but your current ones are working, that’s probably not a reason to raid the emergency fund.
Use your emergency fund to stay in control of your financial life
When finances are tight, especially if you are trying to get out of debt, an emergency fund may seem like a luxury. However, when emergencies hit, you will find that it’s a necessity. To help you figure out how much at risk you could be for serious problems with debt and the ability to save for an emergency fund, download our “How to Manage Debt” guide.
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