Emergency Funds: Everything You Need to Know to Prepare Yourself for a Financial Emergency

Life is full of surprises. Some of those surprises are good news, like receiving a gift that you love. Other surprises can be stressful, especially when they come with unplanned costs. We call these surprises financial emergencies, and sometimes they lead to a need for debt relief.

There are ways to get your finances back on track after an emergency. The key is to figure out which option is the most cost-effective for you.

What Is an Emergency Fund?

An emergency fund is cash you keep on hand to pay for financial emergencies, which may include a sudden loss of income or an unplanned expense. Having an emergency fund can boost your financial security because you'll know exactly what to do when an unplanned expense arises. You'll just use the money you have at hand to pay the bill, and then replenish the emergency fund over the coming months.

Having an emergency fund is the optimal way to navigate unplanned expenses or a job loss. Other options, like relying on credit cards, can lead to a costly debt cycle that can be difficult to break. Having some extra cash standing by could help you avert the need for debt relief programs due to overreliance on credit cards.

Building an emergency fund is a great way to prepare for life’s curve balls. 

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How Much Should You Save for Emergencies?

Everyone needs a different amount of money in their emergency fund. The more you earn and the bigger your budget, the more you need to set aside for unexpected expenses. A baseline should be at least enough money to live for three months with no income. 

That might sound like a huge amount of money, and it is. No one saves up their emergency fund overnight. Start smaller. Even $1,000 could go a long way toward helping you be prepared for things like an insurance deductible or a car repair. 

Your next goal could be to save up half a month's income and then focus on paying down your debt. Once your debt is behind you, you can work toward a bigger cushion. 

You'll want to include costs like groceries and housing expenses when calculating your emergency fund. Extras like streaming services are up to you. You could leave them out if you want. But then if you find yourself out of a job unexpectedly, you may have to cancel these extras until you get yourself back on more stable financial footing.

If you're not sure how much your emergency fund should be, look at your bank and credit card statements from the last few months to figure out how much you typically earn and spend. Use this as your baseline when deciding how much to save.

Your emergency fund needs can and will change over time. For example, many of us spend more as we get older. You might live in a bigger home than you did 10 years ago, or maybe you have two kids now. Adjust your emergency fund accordingly as your needs evolve. Review your emergency fund annually or whenever you experience a major lifestyle change to decide whether to adjust it up or down.

Building Your Emergency Fund Step by Step

Once you've set a savings target for your emergency fund, the next step is to build it. 

Create a savings habit

Decide how much you can afford to save toward your emergency fund each month or pay period. It's OK if it's a small amount. What's more important is consistency. 

Automate your savings whenever possible by setting up a recurring transfer to your savings account. This helps reduce the chance that you’ll spend the money or forget to make the transfer on your own.

Make adjustments to your budget

Review your budget for opportunities to reduce your expenses. Look over your bank and credit card statements for the past few months to find any areas of overspending. If you can, trim back those expenses while you're building your emergency fund.

Another option is to take on a side hustle. Put the extra money you earn into your emergency fund until you've reached your goal. Then, once that's done, you can either stop the side hustle or put that income toward other expenses.

Save windfalls

If you get a year-end bonus from your job or you're expecting a tax refund, put this money toward your emergency fund. For some people, these could be worth thousands of dollars. Even one bonus or refund might be enough to help you reach your emergency fund savings target.

If you don’t want to save all of it, set aside a portion. Use the rest to pay down debt or treat yourself to something you've had your eye on.

Where to Keep Your Emergency Fund

Keep your emergency fund somewhere accessible so you can withdraw funds at a moment's notice. You also want to choose an account that doesn't charge you a monthly fee just for owning it. Some great options for your emergency savings are:

• High-yield savings accounts: These accounts, typically available through online banks, charge few or no fees and they offer some of the highest interest rates you'll find, which could help grow your balance over time.

• Traditional savings accounts: Traditional savings accounts at banks and credit unions are an option as well, though they're more likely to have fees and less likely to offer a high interest rate. 

• Money market accounts: Money market accounts are basically a hybrid of a checking and savings account. They tend to have the higher interest rates of savings accounts with the easy access (check-writing capabilities, debit card, etc.) of a checking account. Some have higher minimum balance requirements than savings accounts.

Scope out a few options before you decide which one works best for you. Consider ease of access as well as costs. 

When to Use Your Emergency Fund

Only use your emergency fund for an actual financial emergency—that is, a completely unplanned expense or bill that you can’t afford to pay. If you use your emergency fund for things you want, like a vacation, then you won't be ready when a financial shock comes your way.

Also, distinguish between unplanned and planned repairs. You usually can't predict when your furnace will go out. That's an unplanned expense. But you can recognize that your roof is going to need replacing at some point. That's something you'd want to save up for separately from your emergency fund.

When an emergency arises, use only what you need. Then, build a plan for replenishing your emergency fund, following the same steps you used the first time.

If you struggle with leaving your emergency fund untouched, consider keeping it at a different bank than your other financial accounts. That way, you won't be able to access those funds as easily, but they'll still be there when you really need them.

Common Financial Emergencies

Financial emergencies break down into two categories: loss of income and unexpected expenses. A loss of income is anything that threatens your ability to earn enough money to cover your bills. This can include things like:

• Job loss: Losing your job can have a significant effect on how much money your household brings in.

• Having your work hours cut: While not as severe as a job loss, this can still leave you without adequate income.

• Death of a breadwinner: Losing a breadwinner's income often brings major shifts to your household finances.

These types of emergencies can be very costly.

Unexpected expenses are any bills arising from an unplanned and often undesirable event. This can include:

• Auto repairs: While auto insurance covers collisions, routine maintenance is usually up to the vehicle owner.

• Replacing appliances: If you're not comfortable fixing a broken appliance yourself, you'll have to pay someone to do it or buy a new one.

• Insurance deductibles: Even if you have home or auto insurance, you usually have to pay a deductible out of pocket before your insurer will pay anything toward the repairs.

You could also wind up in situations that can lead to a loss of income and unexpected expenses. Some examples of this are:

• A serious injury or disability: You might face unexpected medical bills and be unable to work for a prolonged period of time.

• Caregiving for a family member: You may need to unexpectedly care for an ailing family member, forcing you to take time off work and incur new expenses.

• A natural disaster: This could damage your personal property and potentially make it impossible for you to attend your job in the aftermath.

All of these situations are good times to fall back on your emergency fund if you've got one so you can avoid debt and further stress.

Strategies for Coping with a Financial Emergency

The first step in navigating any financial emergency is to take a breath. Take some time to assess the situation calmly. People just like you cope with financial emergencies all the time. You can do it, too. If it's a larger issue that affects more than your finances, like a tree smashing through the roof of your home, make a list of things you need to do to resolve the situation, and prioritize the tasks. Then check them off one by one.

Once you're ready to tackle your finances, survey the resources available to you. For certain emergencies, that might include insurance coverage. Give your policy a quick read, or reach out to your insurance agent if you're not sure what's covered.

You may have more coverage than you think. For example, many auto insurance policies have coverage for rental vehicles, too. Your homeowners insurance policy may cover some lost or stolen items, even if the loss or theft occurred away from home. With all insurance claims, weigh the potential cash you could receive against a possible rise in premiums to decide if this is your best option. 

If you don't have any insurance coverage, fall back on any emergency savings you have first. If that's not enough, try one or more of the strategies listed below. 

Negotiate your bills

If you're struggling with payments due to a financial emergency, contact the creditor about your situation. Some companies will give you additional time to pay, or help you set up a payment plan so you don't incur late fees.

If you genuinely can’t afford to fully repay your debts, you may want to consider debt settlement. This is when you negotiate with your creditors, asking them to accept a smaller amount than what you actually owe. You can negotiate on your own or with the help of a debt settlement company. In a debt settlement program, the monthly payment could be lower than the total of your minimum monthly payments.

Consider a personal loan

Personal loans are loans you could use for just about any purpose. If you expect your financial shortfall to be temporary, you could apply for a personal loan to cover your expenses and pay it back over time. These loans usually have fixed monthly payments over a number of years.

Personal loans usually don't require collateral. Collateral is something the creditor could take from you if you default on the loan. Interest rates for personal loans are typically lower than credit card rates but higher than home equity loan rates. 

Some lenders charge origination and other fees for personal loans.

Consider a home equity loan

A home equity loan could be an option if you’re a homeowner with sufficient equity. Equity is the difference between your home’s value and your mortgage balance. Each lender sets its own rules for how much equity you must have and how much you can borrow.

Applying for a home equity loan is simpler than applying for a mortgage to buy a home. You need to provide information about your home, your income, and your existing debts. 

Most home equity lenders charge a fee for making the loan. 

Find out if you qualify for government assistance

The federal government has programs to help people struggling financially cover basic expenses, including:

• Housing

• Food

• Utilities

• Healthcare

Your state or local government may also provide assistance programs. Charitable organizations like Catholic Charities, Jewish Family Services, the Salvation Army, and other organizations operating in your area are worth looking into. 

Pay with your credit card

Generally, you want to only charge items to your credit card if you know you can pay it all back at the end of the month. But that credit limit can be useful in a pinch when you have nowhere else to turn. If you do this, only charge what you have to, and work to pay it off as quickly as possible.

Tap your 401(k)

If you have a 401(k) and you're experiencing a financial emergency, you might qualify for a hardship withdrawal. If your employer’s plan allows it and your situation qualifies, a hardship withdrawal could be a way to take out money to satisfy an immediate financial need, regardless of your age at the time.

You’ll owe taxes on the hardship withdrawal unless the money comes from a Roth 401(k). You could also owe a 10% early withdrawal penalty if you're under 59 and a half. For these reasons, and the fact that early withdrawals slow the growth of your retirement savings, consider this an option of last resort.

Strategies to avoid

There are lenders that promise quick cash and minimal paperwork, but they often carry outrageously high fees and interest rates. Taking the wrong loan could lead to a costly debt cycle that proves to be more trouble than the initial financial emergency that sparked it all. 

Some options to avoid are:

• Payday loans: Payday loans are short-term loans that promise access to quick cash, but they can have interest rates of nearly 400%. 

• Auto title loans: Auto title loans often have high costs and short repayment terms. They also use your vehicle as collateral, so you could lose it if you don't make payments on time.

• Credit card cash advance: Some credit cards enable you to access some of your credit line as cash. But there's usually a fee for this and cash advances begin accruing interest immediately.

Weigh the Pros and Cons of Your Options in a Financial Emergency

Building your emergency fund is one of the best things you can do for your financial security. If you're struggling to pull it off because of unmanageable debt, Freedom Debt Relief could help you get out from under your debt so you can get back to building your savings.