Having a solid emergency fund is widely considered the foundation of personal finance. Americans, however, are notoriously bad at saving. According to the Federal Reserve’s most recent numbers, we’re only saving less than 4 percent of our income. That means for every $100 earned, we’re saving just $4.
Not having an adequate emergency fund can lead to significant challenges that have the potential to compound. Take one unexpected trip to the car mechanic, for example. If you spend $1,000 on a repair, use a credit card to finance it, and you can only afford to make minimum payments, it could take you nearly five years to pay it off and cost you an additional $395 in interest charges.
What is an emergency fund?
An emergency fund is simply a pot of money you set aside for unexpected events, such as medical expenses, job loss, traveling for an unexpected death, or as mentioned above, car repairs. You may want to make a list of scenarios that qualify as an emergency as your definition may change over time. This may help if you’re an impulsive spender who may be tempted to spend on events that are urgent, but not true emergencies. It is also important to note that the funds you set aside for emergencies should be in a separate account, away from the funds you use on a daily basis.
How much should be saved in an emergency fund?
The most common answer for the amount needed for an emergency fund is three to six months worth of your living expenses. These would be the non-negotiable essentials you need to get by, such as housing, groceries, gas, and transportation.
Like most rules-of-thumb, it can be misleading. Your emergency fund should reflect the financial stage that you’re in and the type of situations you may encounter.
Three to six months worth of expenses
This amount is for people who may be single, young, have no children, have a reliable steady income, and are geographically close to family. Because of your circumstances, you don’t have any dependents to care for and your income is relatively steady, so you may be able to get away with saving less than, say, a breadwinner parent with two kids who is starting a new business.
Worst-case scenario, you may be able to lean on relatives in close proximity if you fall on hard times.
If your emergency is health-related, your recovery time is usually shorter than a person who is much older. Also, if your emergency results in unemployment, you are more likely to get a job faster than someone 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. The AARP suggests that finding a reemployment between ages 45-70 may result in “ lower pay, with fewer hours, and with limited benefits.”
Six to nine months worth of expenses
The six-month benchmark typically fits for most people and generally works for those who have at least one of the following situations: children under the age of 18, owns a home, or is married. In most cases, if you have at least six months worth of savings built up, that would 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.
How to build an emergency fund
Building up your emergency fund won’t happen overnight.
“Thinking about saving enough to cover six to eight months of expenses is daunting,” said financial expert and author Jason Vitug.
Depending on your income, expenses, and the benchmark you’re trying to hit, it could take years to reach. This should not discourage you though. Remember, just having $1,000 puts you ahead of the vast majority of Americans.
As a starting point, Vitug encourages people to look at their auto insurance deductible.
“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.”
Here are some strategies to build up your emergency fund
The first step is figuring out what your expenses are. You could use apps like Mint or Personal Capital to help save time. They can help establish a trend of how you spend money over time and can also be helpful to those who have unpredictable incomes.
Once you have an idea of what your expenses are, you should set up an automatic savings plan. This will ensure that you are saving at regular recurring intervals and building up momentum.
If you’re anticipating a tax refund next year, that could also be an opportunity to make significant progress toward meeting your goal. You could also boost your emergency fund by moonlighting (taking on an additional job), selling your unwanted items on Craigslist, or taking part in a savings challenge.
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 59 ½.
If you choose to use a Roth IRA for your emergency fund, you may want to consider your investment options carefully as you don’t want to take on too much risk. Doing so could cause you to lose your money at the moment you need it the most.
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.
Building your emergency fund isn’t the most exciting financial topic, but without this foundation, your ability to cover emergency expenses may be futile. It is much better to have it and not need it, than need it and not have it.