Why You Need an Emergency Fund and How to Build It
Unexpected life events such as sudden job losses and medical emergencies can hurt your finances. But having an emergency fund can make a big difference in how you navigate those difficult times.
Emergency savings provide a safety net for unforeseen expenses, preventing you from falling into debt or depleting your long-term savings accounts. Here’s what you should know about emergency funds, including how you can begin to build your own.
What is an emergency fund and why does it matter?
An emergency fund is a cash account specifically designed to cover unexpected expenses. This isn’t your vacation or retirement fund; it’s a separate account you can turn to when disaster strikes. Think of this as your financial air bag — it cushions those blows.
Car accidents, home repairs and sudden job losses, for example, can have a significant effect on your financial stability. Without an emergency fund, these events can quickly lead you into debt. You might be forced to tap into your retirement savings, borrow at high interest rates or use credit cards to cover your basic living expenses.
In short, an emergency fund provides the peace of mind that comes with knowing you can handle unexpected expenses without jeopardizing your long-term financial goals.
How much should you save in an emergency fund?
The general rule of thumb is to save three to six months’ worth of living expenses in an emergency fund. This is generally enough to cover your essentials, such as mortgage or rent payments, utilities, and transportation and insurance costs, until your financial situation stabilizes.
However, you may want to set a higher savings goal equal to expenses of nine months or more.
To determine how much you need to save in an emergency fund, consider these factors:
- Job stability: If you work in a stable industry with a low risk of losing your job, a smaller emergency fund may be sufficient. But if you work in a more volatile field, or if you are self-employed, you might want to set a higher goal.
- Income fluctuation: If your income can vary, a larger emergency fund might be needed to cover cash flow gaps throughout the year.
- Children: If you have kids or other dependents, you may need a larger emergency fund to cover their needs.
- Debt level: If you have a lot of debt, a larger emergency fund may be necessary to avoid taking on even more debt during a crisis.
How to build an emergency fund in 5 steps
Here are some steps you can take to build your emergency fund:
1. Choose an account for your emergency fund
Before you can start saving, you will need to decide where to keep your emergency fund. Quick and easy access to your money is key.
Place emergency savings in an interest-bearing account you can get to without fees or penalties. Good options include high-yield savings accounts and money market accounts.
Both of these options can offer competitive interest rates. They are typically federally insured, meaning you can trust that your money is safe until you need to access it.
Longer-term savings vehicles such as CDs, which usually include a penalty for early withdrawal, are not ideal. You could also open a checking account that you earmark for your funds, but this type of account normally won’t accrue interest.
2. Set a monthly savings goal
The standard guideline is to save three to six months’ worth of living expenses, though some people may want to set a higher goal.
Once you have a target in mind, do some quick math to calculate how much you can afford to save monthly. This will give you an idea of how long it will take to build your emergency fund.
Let’s say you aim to save a total of $10,000, and you can afford to save roughly $400 a month. It will take you about two years to build your savings — though choosing a high-yield savings account can help speed up your progress.
Breaking your long-term goal into more attainable short-term goals can make the task of building an emergency fund seem less daunting. You can break this down further into a goal of $100 per week.
3. Make saving automatic
Consistently contributing to your emergency fund will be key. To aid in the process, consider setting up recurring transfers from your paycheck or checking account to your savings account.
If you receive your paycheck through direct deposit, many employers will allow you to split this deposit across multiple accounts, sending a portion of each paycheck directly to your savings. If you don’t use direct deposit, you can also contact your bank or credit union to schedule automatic transfers from your checking to your savings account.
Either way, automatic contributions ensure that, as you spend money, you also save it. This approach makes saving for an emergency fund that much simpler.
4. Add supplemental income
Unexpected sources of income can significantly accelerate the growth of your emergency savings. If you come into extra money throughout the year, consider adding it to your emergency fund.
Examples of supplemental income include tax refunds, work bonuses, freelance payments, gifts and inheritance funds. If you add this extra cash to your emergency fund, you may reach your savings goal sooner than you anticipated.
5. Monitor your progress
Make sure you track your progress to see if you’re on course to meet your goal. If you aren’t saving as much as you planned, do some digging to figure out why.
Maybe your goal is too high, or perhaps you haven’t dialed back spending as you had intended. Either way, try not to get discouraged.
Reevaluate your budget, identify areas where you can cut back, and adjust your monthly savings goal accordingly. Keep in mind that even saving a small amount per month is better than saving nothing at all.
Frequently asked questions
How do I start an emergency fund?
To start an emergency fund, you’ll first want to create a budget to understand your monthly earnings and expenses. Determine the amount you need to save for the next year or two, and then break this into smaller monthly or weekly savings goals.
Where should I put my emergency fund?
Emergency savings are best suited for easily accessible, interest-bearing bank accounts, such as a high-yield savings or money market account.
How much should I save in an emergency fund?
The general recommendation is to save enough to cover three to six months’ worth of living expenses. But some people may want to save enough to cover nine months or more, especially if they have multiple dependents.