The Basics of an Emergency Fund
How to build a financial safety net.
Unexpected expenses can derail your financial goals. Whether you’re saving for a home, paying off student loans or credit card debt, or just trying to get some more breathing room, these expenses can cause severe financial burdens if you don’t have a plan for dealing with them.
Stimulus payments, enhanced unemployment benefits and the expanded child tax credit provided a lifeline in 2020 and 2021 for many Americans who live in financial precarity. Still, a recent survey found that 51% of Americans have less than three months’ worth of expenses saved, and 25% have no emergency savings at all.
Without emergency savings, you’re more vulnerable to surprise medical bills, car accidents, a job loss or other events that create financial stress. And when most people without emergency savings get an unexpected expense, they put it on a credit card, which can create more long-term financial issues.
A critical step in creating your own personal safety net is to start an emergency fund. There’s great power and security in putting money away you can easily access in the event of an emergency. An emergency fund adds a buffer and can help stave off financial ruin. It can even give you the freedom to quit a toxic job and cover your expenses during the transition period to the next one.
Here’s what you should know about starting an emergency fund.
How Much Should Be in My Emergency Fund?
Typical financial advice says you should keep three to six months’ worth of expenses in an emergency fund.
Exactly how big your emergency fund should be depends on your situation and your job security. The more secure your job is, the less you can get away with having in your emergency fund. If you work in an unstable industry and your job is vulnerable to a recession, you might want more.
Regardless of what formula you decide to use, it might be a good idea to have a minimum equivalent to your combined insurance deductibles: auto, health, renters’, home insurance, etc.
Where Should I Hold My Emergency Fund?
An emergency fund should be easily accessible in an FDIC-insured savings account. It shouldn’t be tied up in investments like stocks or bonds, which can lose money in the short-term.
If you have a checking account at a major brick-and-mortar bank, you may be tempted to open a savings account there. But these banks typically pay only 0.01% interest on savings deposits.
Online banks, such as Ally, Discover and CIT, tend to pay somewhere around 0.4% and 0.5%. You can find higher rates if you’re willing to jump through some hoops, but generally this is the best you’re going to get, and that’s okay. You’re sacrificing future return for current stability.
Some institutions offer “cash management” accounts with attractive interest rates or rewards. While these aren’t technically bank accounts, they’re usually FDIC-insured and they can serve as your emergency fund.
What an Emergency Fund Is and Isn’t For
An emergency fund is for unplanned expenses, like a medical bill, a car accident or a job loss. It isn’t for regular or annual expenses. So if you know you take your car in for service once or twice a year, you would ideally be planning for that already in your budget. But if your car were to break down, an emergency fund would cover the cost of repairs.
Rather than stretch the meaning of “emergency,” you should keep other savings for travel and consumer items separate. Your emergency fund should also be separate from other goal-based savings, like for a house or education.
Start Small
Saving six months of your household expenses may seem difficult, especially if you’re also paying off debt. But starting just a small emergency fund of $1,000 can help you break the cycle of adding more debt every time an emergency arises.
You can set up automatic transfers each month from your checking account to your savings account, or you can have a portion of your paycheck go into savings. Another great way to build your emergency fund is to use small windfalls, like a bonus at work or a tax refund, and deposit them into your savings account.
Building an emergency fund will help you focus on long-term goals such as investing and buying a home. It’s a great place to start if you want to build resilience to whatever financial headwinds you may face.