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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.
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?”
And who doesn’t want less stress in life, right?
On top of saving you some stress, creating an emergency fund can also save you money. By using the funds you’ve set aside for a financial emergency, 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 priorities, so no two emergency funds will look exactly the same. Your emergency fund 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 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–$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 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 an 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 answered “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.
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.
And be mindful of when to dip into your emergency fund. Don’t make hasty decisions when deciding to pull money out — make sure it’s a true financial emergency.
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.