Emergency fund basics

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In a Nutshell

An emergency fund, a savings account set aside for unexpected life events, can offer much-needed support during a time of need.

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Life happens quickly. If you’re not prepared, unforeseen expenses and emergencies can send your finances into a tailspin.

The loss of a job, illness, injury, major house or auto repair, or any other unexpected bill or emergency can cause a devastating financial setback.

An emergency fund is a savings account you set up for just these types of financial emergencies. It’s not a normal savings account, which you can use to pay for a planned purchase, like a new computer or even a down payment on a house. Instead, emergency funds should only be used for true emergencies.

And because unexpected and costly life events can happen to anyone, an emergency fund should be part of everyone’s financial plan, regardless of income.

Worried about your finances because of the coronavirus pandemic? Check out our resources.

Why do you need an emergency fund?

An emergency fund provides a cushion to help you handle sudden financial emergencies. And saving now so that you can deal with future emergencies can help keep stress levels down by taking some of the guesswork out of the question “How in the world am I going to pay for this?”

On top of saving you some stress, creating an emergency fund can also save you money. By using your emergency savings, you may be able to avoid taking out a high-interest loan or reallocating money used to pay everyday bills, leaving those bills unpaid and past due.

How much should be in an emergency fund?

Everybody has different financial goals, so emergency funds can look different from person to person. Your emergency savings should mirror your own expenses, priorities and habits.

Many experts believe you should have enough money saved in your emergency fund to cover at least three to six months’ worth of living expenses. Critical living expenses include housing, food, transportation, medical care, utilities and current debt. Estimating your monthly costs for these necessary expenses should help give you a realistic idea of how much you should have in your emergency fund.

Because saving money can seem like a daunting task, the best approach is to set realistic goals. If you set an impractical savings goal, you’ll be more likely to fail. Start with a goal of saving $300­ to $500 and raise the limit by a few hundred dollars each time you meet your goal. Just think — the more cash you save in your emergency fund, the more prepared you’ll be for life’s costly surprises.

Where should you keep your emergency fund?

Now that you have a rough idea of how of much you need to save, the next step is determining where you’re going to keep your money. Sure, putting your spare cash in a piggy bank or shoe box will work, but these options are uninsured, and you won’t be earning interest. And with the recommended amount of emergency funds as high as three to six months of living expenses, you’ll want to make sure your money is physically protected and insured by the FDIC or NCUA.

So you’re not as tempted to spend it, emergency funds should be in a dedicated account separate from your checking and savings accounts.

Here are a few suggested places to keep your emergency funds.

  • A regular savings account allows easy access to your funds. It usually earns a low interest rate and requires a low minimum balance to avoid fees.
  • A high-yield savings account is a savings account that typically has a higher interest rate than a traditional savings or checking account.
  • A money market account allows easy access to your funds and typically earns a higher interest rate than regular savings accounts, but will most likely require a higher minimum balance to avoid fees.
  • A U.S. Certificate of Deposit or savings bond can earn a high interest rate and limits accessibility to funds if you’re tempted to spend them. But be aware that if money is removed before the maturity date, you’ll likely have to pay penalty fees.

When is it appropriate to dip into your emergency fund?

If you’re deliberating about whether to dip into your emergency fund account, ask yourself this question: If your emergency fund were encased in glass with a warning sign that says, “In case of emergency, break glass,” would you break the glass? Is the expense you’re considering truly an emergency?

If you answer “No” to either question, then you have your answer on spending the money. An emergency fund is meant to cover just that — an emergency.

If you’re counting pennies to put food on the table, or your power could be shut off if you don’t pay the bill, it’s reasonable to consider your situation an emergency. That would be the appropriate time to lean on your cash cushion to get yourself back on your feet.

But if a true emergency expense does come up and you need to dip into the fund, make it a point to replenish your fund — and even add to it — as soon as you reasonably can.

What’s next?

An emergency fund can reduce the stress of the unknown and help save you money in the long run. To get your emergency fund started, consider your monthly critical expenses and begin with an obtainable goal. Then, make a budget. If you’re able to, consider allocating more money to paying off debt and building up your emergency fund than you typically would.

Setting yourself up with the financial safety net and peace of mind that an emergency fund offers can help prepare you for life’s unexpected curveballs.

Worried about your finances because of the coronavirus pandemic?

You may need to dip into emergency savings while the country deals with the economic effects of the coronavirus pandemic. But government relief measures and additional assistance provided by the CARES Act may also be able to help you out.

Lenders may also be willing to work with you if you need some assistance paying off your auto loan, mortgage, credit card or student loan. If you’re in a financial emergency, you may need to use your savings — but look into relief options that may be available to you first.

Government relief options for small-business owners

Shelter-in-place orders are hitting small businesses hard. Whether you have an emergency fund or not, taking advantage of government relief measures may help you save your business. Through the CARES Act, self-employed workers and small-business owners may receive some assistance.

About the author: Sarah Schaut is a Canadian living in sunny Florida. She’s an economic crimes detective at a city police department and an expert in credit, fraud and mortgages. Read more.