According to a Federal Reserve survey, 39% of American adults say they couldn’t come up with $400 to cover an unexpected expense, or could only do so by borrowing or selling something. That’s a problem.
An emergency fund should be a critical part of every person’s finances. A rainy day fund, as some call it, provides much-needed security when unexpected expenses occur. It also helps you avoid going into debt to cover those costs.
As the name suggests, an emergency fund is money set aside in a separate account only to be used in case of true emergencies. This fund should not be treated as a personal fund for impulse buys or for large expenses that can be anticipated—such as an annual vacation. Instead, it should be a savings account used only for costly, necessary and unpredictable items such as medical bills or car and home repairs.
In this guide to emergency funds, we’ll cover the following:
- How much you should save for emergencies
- Where to keep your emergency fund
- Tips on saving up an emergency fund
How Much You Should Save for Emergencies
An oft-repeated rule of thumb is to save three to six months of expenses as an emergency fund. That’s a worthy goal, for sure. Yet you needn’t blindly follow any financial rule of thumb—particularly one that may not be realistic in your own case.
To set your emergency fund goal, it’s helpful to consider a few things.
First, recognize that it can take months to save even a single month of expenses. For example, let’s assume you spend $4,000 a month. if you are able to save 10% of this amount, or $400 a month, it will take you 10 months to accumulate one month of expenses in an emergency fund. Save just 5%, or $200 a month, and it will take you 20 months.
Now multiply these time periods by three or six and it’s clear that building an emergency fund equal to three to six months of expenses is for many a long-term goal. The point is that while your ultimate goal may be to have six months of expenses saved, you may need to start with a smaller goal you can attain in a reasonable amount of time. One month’s worth of take home pay is a solid starting point. This allows you to start building an emergency fund while also addressing other financial priorities, such as debt repayment and retirement savings.
Second, recognize that there are two types of financial emergencies. The first is an unexpected expense, such as a car or house repair. Such emergencies, while potentially expensive, are limited in time and fixed in amount. The second is an unexpected loss of income. A sudden bout of unemployment can be a short-term problem or a much longer, severe challenge, depending on your own circumstances and the economy.
For this reason, consider the stability of your income when setting your emergency fund goal. If you are a programmer in Silicon Valley, you’ll likely have endless job opportunities. (Unless, of course, there’s another tech bust.) A relatively smaller emergency fund (as a multiple of monthly expenses) may be acceptable. By contrast, if you work in the only manufacturing facility in a small midwestern town, your opportunities may be more limited, necessitating an emergency fund that covers more months of spending.
Third, estimate your costs for critical expenses. These include housing, food, healthcare, utilities, transportation, and debt repayment. Just because you spend $4,000 a month now doesn’t mean it would take that much to survive. You may find that your critical expenses are significantly lower than your current monthly spending, which includes such discretionary outlays as restaurants and entertainment.
Where to Keep Your Emergency Fund
The purpose of an emergency fund is to have your money immediately available in case of an unforeseen event. As such, online savings accounts, money market accounts or certificates of deposit are common places to keep your emergency fund, since you won’t have to worry about the value of the fund suddenly going down if stocks tank.
A high-yield savings account is arguably the best option for an emergency fund. In your savings account search, look for an account with a higher than average interest rate and no monthly fees or balance requirements. These accounts also are federally insured up to $250,000.
Another option is to keep your emergency fund in a money market account. Money market accounts are similar to savings accounts in that some offer higher yields. Moreover, since money market accounts are easy to use, charge no penalties for withdrawals and may even offer check writing privileges, they are another good option for stowing your emergency fund.
A third option is a certificate of deposit. Certificates of deposit, or CDs, offer a fixed rate of return for a specific duration of time. The terms of a CD generally range from one month to seven years, with longer terms earning higher interest. Keep in mind that most CDs lock these savings away for the duration of the term. Taking the money out early typically incurs an early withdrawal penalty.
If you want to use CDs for your emergency fund, consider taking out multiple CDs with different terms so that funds become available without penalty every six to 12 months, or even more frequently. This sort of CD “ladder” minimizes the chance you’ll be hit with a large early withdrawal penalty.
Tips on Saving Up an Emergency Fund
It is a good idea to make building an emergency fund one of your highest savings priorities. To do this, in addition to mapping out your goals, chart your monthly income and expenses. Make sure to distinguish wants, such as movie tickets and dinner out, from true necessities, such as rent or mortgage and utility bills.
Once you know your critical expenses, create a plan to set aside a certain amount each month. Have this amount automatically transferred from your existing checking account. By automating the process, you are far more likely to stick to the plan. Another option: Ask if your workplace offers automatic payroll deductions for emergency savings. According to a 2018 survey by the Employee Benefit Research Institute, while only 11% of employers offered this, another 9% were planning to add this option as part of growing interest in employee financial wellness programs.
One good way to turbocharge your emergency fund is to use your tax refund. During the 2019 regular tax filing season, IRS statistics show, 95.7 million households got refunds averaging $2,725. The IRS gives you the option of direct depositing your refund in more than one account. (You’ll need to fill out Form 8888 to do this.) So consider directing part of your refund this year into your emergency fund account. The rest can go into checking (say, to pay off credit card debt) or even into an individual retirement account.
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