Everybody knows you need an emergency fund. What you might not know? How to get from point A, when you’re barely making ends meet, to point B, when you have a safety net to support you during troubled times.
“Extra” money can be hard to come by. And when you do find a little extra in your budget (or pocket), one of the hardest things to do is to set it aside in case you need it later.
But setting aside funds in case you need them later is one of the smartest things you can do with your money. As the name suggests, an emergency fund can help during a catastrophe, which could be anything from a plumbing disaster to unemployment. It can also help you get through any unexpected and potentially costly event, such as a major car repair, a health crisis, or the gap between paychecks during a job transition. In fact, when something unexpected happens, you can’t afford not to have an emergency fund.
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 money or use your credit card to cover an expense that comes out of left field. Surprisingly, 55 million Americans have nothing saved in for such an expense. 40% don’t have enough saved to cover an expense of $400.
With statistics like these, it’s easy to understand why a lack of savings throws many people into a financial disaster. Having an emergency fund prevents you from slipping into dangerous amounts of debt. After all, even if you are staying current with regular bills, one unexpected expense could force you to start relying on credit cards and charging amounts you can’t afford to pay off in full at the end of the month. So you start carrying over debts from month to month, they grow higher and higher each month, and it can become harder and harder to keep up with the mounting interest and higher payments.
Benefits of an emergency fund
You can think of an emergency fund as a personal insurance policy. Instead of paying premiums to an insurance company, you’re setting aside money that you can use if you need it.
Emergency funds provide a piece of the financial stability puzzle. “Financial stability” is a broad term that means different things to different people. For some, it means having enough to make it through a month and pay all the bills, with something set aside for a few unplanned expenses. For many, it’s the ability to save a certain amount each month. For others, it means being able to send their kids to college, take a vacation, and feel confident about their lifelong financial security. The common thread in all is the ability to cover routine expenses and have some money left over.
With an emergency fund, you’ll be able to avoid relying on high interest credit cards in a pinch, or worse, turning to an even higher interest payday loans.
By avoiding these types of high-interest debts, you’ll avoid payments that only get higher as you struggle to get out of debt.
Moreover, you’ll decrease your level of financial stress if you have an emergency fund in place. 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 much should you save in your emergency fund?
How much to save in the emergency fund will depend on each individual’s or family’s situation. Conventional wisdom says that it is a good idea to save six to nine months of basic living expenses in an emergency fund. If you have an unexpected event that affects your income, that level of savings ensures that you’ll have enough money to get by for a few months, until you can get your feet on the ground again.
Saving six to nine months of living expenses may sound daunting. If you need to start at another level, 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 $250? A medical bill for $500? Save until you have at least that amount available. Then keep building toward the goal of six to nine months of basic living expenses.
Also, remember that “basic living expenses” do not necessarily total the same amount as your salary. 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 (big or small).
To help you determine a savings goal that represents six months of living expenses, you can use a simple emergency fund calculator. By inputting your monthly expenses, you’ll be able to quickly assess your emergency fund status, and how much more you need to save.
Where to keep your emergency fund
Emergencies, by definition, happen unexpectedly. This is why it is vital that your emergency fund be easily accessible (within one or two business days), but not so accessible that you’ll be tempted to spend from it when there isn’t an emergency. Consider a traditional savings account or money market account—one that is separate from your main account you use for routine expenses. 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 much risk with these funds, and quick access to your funds is essential.
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—like mortgage or rent—first. Adding to your emergency fund is important, but you never want to put your home at risk. 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. It’s hard to build an emergency fund if you are trying to pay off credit card or other debt. The more you do to reduce debt, the more easily you will be able to save. You may be able to trim your budget and do some major belt-tightening to accelerate your debt payoff. Or, if you have accounts with high interest rates, you may want to look into credit counseling or a debt consolidation loan to reduce the interest you pay. If you have significant debt—generally $7,500 or more—and are struggling to make minimum payments, talk with a reputable debt settlement company like Freedom Debt Relief about what they can do to help. You can download our “How to Manage Debt” guide to learn more about these different options.
• Don’t neglect retirement savings. In general, it’s smart to build a solid 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. If it’s at all possible to contribute—even a small amount—toward your matched retirement plan while you pay down credit card debt, it’s wise to do so.
• 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. Every little bit helps. If you can set aside $25 a week, you’ll save $100 by the end of the month. At the end of the year, you will have saved more than $1,000.
• Automate your savings. You will be less likely to miss money that you do not see. See if you can set up an automatic transfer from your primary checking account to your emergency fund savings account each month. And remember, don’t carry a debit card that is tied to the emergency account.
• Save your windfalls. It is a good feeling to pay off a car loan or credit card bill, 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. If you were paying $200 per month for a car loan, for example, that amount could go right into emergency savings once you pay off the loan.
• Find savings—at home, at work, at the store. With a little thought and creativity, you can find many ways to trim your spending. These money-saving tips can get you going in the right direction. Direct the savings you get to your emergency fund.
• Generate extra income. Many people find it possible to earn money for their emergency funds by cleaning out their basements, attics, garages and drawers, and selling unneeded items on online sites like eBay and Craigslist or at a yard sale. You may be able to handle a part-time job, or babysit, tutor, do yard work or shovel snow, and then devote the money you bring in to the emergency fund.
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 pay off the expense in full and on time at the end of the month.
Recurring (annual, quarterly, semi-annual) expenses do 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.
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 not a reason to raid the emergency fund.
A key part of using your emergency fund is replenishing the fund. After you use your emergency fund savings for a true emergency, you must build it up again to its previous level.
If it was not already at the level of covering six to nine months of living expenses, don’t stop there—keep on building.
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. It is not. When emergencies hit, you will find that an emergency fund is a real 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. And if you ever want to talk about your situation, call one of the Certified Debt Consultants at Freedom Debt Relief. They are available at 800-230-1553 to answer all your questions, with no obligation.
With time and patience, anyone can be prepared for the unexpected. By committing to building an emergency fund, you are taking the right steps to assure you’re in control of your financial life.