Banking 101: Why You Need an Emergency Fund and How to Build It
Note: This article is part of our Basic Banking series, designed to provide new savers with the key skills to save smarter.
An emergency fund is vital to your financial stability. Having a highly liquid pool of money to dip into when unforeseen expenses pop up means you won’t be forced to sell investments at a loss, or fall back on expensive credit card debt.
While experts disagree on how much you should have saved in an emergency account — common advice varies from three months to nine months of living expenses, or even more — two analysts recently attempted to find a more concrete answer. Economists Emily Gallagher and Jorge Sabat found that if you have at least $2,467 stashed away, you should be able to weather any short-term, unexpected financial hardships.
That amount doesn't seem too steep, but for many Americans, it's a mountain they haven't even attempted to climb. A Financial Industry Regulatory Authority (FINRA) study found that 46% of adult Americans have nothing saved as emergency funds. This is indeed a big problem.
What is an emergency fund and why does it matter?
An emergency fund is a pool of money you set aside in a savings account for unexpected events, such as medical expenses, job loss or necessary travel needs. The account should be separate from your checking account, other long-term savings accounts and retirement investment accounts.
You should make a list of scenarios that qualify as an emergency as your definition may change over time. This could help if you’re an impulsive spender who may be tempted to spend on events that are urgent, but not true emergencies.
How do you start an emergency fund?
An emergency fund is a key financial goal, but accumulating the full amount won’t happen overnight. The first step is figuring out how much your expenses are — try using a budgeting app like Mint or Trim. Apps like these can help you establish a trend of how you spend money over time and can also be helpful to those who have unpredictable incomes.
Once you have quantified your monthly expenses, set up an automatic savings plan. This will ensure that you are saving at regular recurring intervals and building momentum to reach your full emergency fund goal. You should consider boosting your emergency fund with cash windfalls, like tax refunds or job bonuses. You could also increase your emergency fund savings rate by taking on a side hustle.
How much should be saved in an emergency fund?
Many experts suggest that you should have three to six months of living expenses saved in your emergency fund. These expenses are the non-negotiable essentials you must have to get by, such as rent or mortgage payments, groceries and transportation costs.
Everybody has different needs, however. Your emergency fund should reflect your financial stage of life and the type of emergency situations you may encounter.
If you have ongoing medical care issues, they should be accounted for in your emergency fund calculations. Do you depend on an old car to get to work?
Three to six months of expenses
This amount is for people who may be single, young, have no children, have a reliable steady income, or are geographically close to family. Depending on your circumstances, if you don’t have any dependents relying on you and your income is relatively steady, you may be able to get away with saving less.
Younger people face fewer medical emergencies, and their recovery time can be quicker. Additionally, younger people find work after becoming unemployed in less time than people over age 50, according to one study led by the Georgia Institute of Technology's School of Psychology and University of Minnesota's Carlson School of Management. An AARP study of recently unemployed workers found that 45% of older jobseekers (defined as 55 and older) were out of work for 27 weeks or more.
Six to nine months of expenses
An emergency fund equal to six to nine months of expenses is a good fit for people who are married, have children under the age of 18, or own a home. In most cases, if you have at least six months worth of savings, it should be adequate to recover from temporary setbacks.
Nine months or more worth of expenses
The nine-month emergency mark typically applies to those who are entrepreneurs, self-employed, or those who have an unpredictable income. The longer time frame should help balance any seasonality or slow periods that may occur in addition to the possible scenarios listed above.
8 reasons you need an emergency fund
You own a car
If you own a car, it will eventually require repairs. And car repairs don't come cheap. AAA says the average cost of car repair is between $500 and $600. Your emergency fund can help ease that pain.
Financial expert and author Jason Vitug encourages people to take their auto insurance deductible into account when building an emergency fund.
“If it’s $500 or $1000, aim to save enough to cover that deductible,” he said. “It helps people set a goal. Realize it. And continue to save more.”
- You have kids
- You're digging out of debt
- You're anxious
- You're single
- You've just been laid off
- You’re a freelancer
- You own a home
Life is unpredictable. When you have kids, life is wonderful, but it can also be much more expensive. If you have just one child, the Department of Agriculture says you'll shell out around around $233,610 by the time he/she turns 18.
An emergency fund is a great safety net for all the unpredictable moments that come with raising kids. For example, your child could require emergency medical treatment and you need to pay some of the bill out-of-pocket. Use that emergency fund to keep yourself from incurring medical debt.
An emergency fund can help you continue paying down debt when trouble strikes. Let's say you’re making good progress on paying down your credit card balances when your refrigerator breaks. Now you're faced with a dilemma: Should you pause paying off that debt so you can buy a new fridge? This is a textbook case for an emergency fund. Dip into it to pay for the new fridge, while holding steady on your plan to get out of debt.
When it comes to mental health, money matters. According to a report from Northwest Mutual, 55% of Americans feel "high" or "moderate" levels of anxiety about unplanned financial emergencies. Having a well-stocked emergency fund can go a long way to calming your financial anxiety.
If you're single, that likely means you may have only one stream of income to lean on. If you become unemployed, or face a medical emergency that disrupts your income, an emergency fund could be your sole source of financial support. Make sure you're stocking it for those times when life deals you a bad hand or two.
Life is plenty stressful when you suddenly find yourself without a job. The Bureau of Labor Statistics says it takes an average of 21.8 weeks to find employment. That's a long stretch without regular income. Make things easier on yourself by having an emergency fund to cover expenses while you search for new employment.
According to a study from Upwork and The Freelancers Union, 57 million Americans freelance. If you're one of them, you know your income stream can be unpredictable. Sometimes it feels like your cash flow is blasting from a fire hose, and sometimes it slows to an unsteady trickle. Build up your emergency fund when work and money is plentiful, then draw it down to cover times when work is less abundant.
One of the joys of home ownership is that when things go wrong, you have to be able to cover the cost. Perhaps your roof springs a leak and it can't be simply patched back up. According to a report from HomeAdvisor.com, the average cost of a roof installation is $6,626. Your emergency fund can help you deal with expenses that crop up, like the refrigerator above or that leaky roof.
Where to put your emergency fund
The key to an emergency fund is that you can easily access the cash in a pinch. That means long-term investment vehicles like a 401(k) or even a CD are not the best options.
“Ideally, emergency funds are kept in cash in either a checking or savings account, but it is possible to hold an emergency fund in other locations,” said Cleveland-based Certified Financial Planner Alex Rupert.
If you’re torn between saving for emergencies or saving for retirement, Rupert suggests taking a hybrid approach. Set some cash aside in a regular savings account that you can easily access for minor setbacks, like a car repair.
From there, you could consider starting a Roth IRA, which can serve dually as a savings vehicle for emergencies and for retirement.
Unlike a traditional IRA, the Roth IRA allows you to withdraw your contributions without paying the IRS penalty.
Rupert reiterates that using your Roth IRA for an emergency should be seen as your secondary option, as your savings accounts should be your first line of defense. Your Roth IRA should not be used for minor unexpected setbacks like a car repair or a medical bill. It is better suited for true hardships, like a major illness or extended unemployment, as it may be a better option than taking a loan from your 401(k) or making a distribution before age 59½.
For those who prefer using a savings account, consider looking into credit unions and online savings accounts as they tend to pay more in interest than larger banks. Certificates of deposit (or CDs) are an option as well, but, unlike a savings account, you are usually not allowed to withdraw from a CD without penalty unless your CD has reached the maturity date.
However, depending on the bank, there may be a way to withdraw the interest instead, allowing you to sidestep the penalty.
The bottom line
Building your emergency fund isn’t the most exciting financial topic, but it is arguably one of the most important. Without this foundation, your ability to cover emergency expenses may be futile. Do the research to find the best account to stash your cash and then make sure you're saving something every month. Life is unpredictable and your emergency fund will help you deal with that. It is much better to have an emergency fund and not need it, than need it and not have it.
Now that he is gone, she no longer has to worry about those bills so she has decided she will use the savings to buy much needed appliances and other things she did without trying to take care of him. The moral of this is that such savings don't have to be left untouched forever. They can be for true emergencies or just saved up for particular purchases one may need or want. The experience of learning to save for what we call that emergency fund, can be the shove we need to get us into the habit of "saving" especially if we have a goal in mind for the fund.
DEBT rules modern economies, not savings.
How times and attitudes have changed.............