In a NutshellUnforeseen expenses or a sudden drop in income could throw your financial life into chaos. Building an emergency fund, with three to six months’ worth of living expenses, could help protect you from taking on debt or dealing with dire consequences, like home foreclosure.
Financial setbacks can happen to everyone, but an emergency fund helps ensure that they’re mere bumps in the road, not financial disasters.
In 2017, more than a fifth of adults surveyed reported facing an unexpected medical expense, with a median cost of $1,200, according to a survey by the Federal Reserve. Medical bills are just one of many surprise costs that could cause major problems if you don’t have the money to cover the expense. An emergency fund is just what it sounds like: money set aside to help protect you when you face costs you didn’t plan for or if your income suddenly drops.
- Why do you need an emergency fund?
- How much should you save for an emergency?
- How can you build up your emergency savings?
- Where should you keep your emergency fund?
- When should you spend from emergency funds?
Why do you need an emergency fund?
Emergencies are, by definition, unexpected situations that require you to act immediately. While you can’t know when an emergency will hit your household, it’s highly likely that you’ll have to face an emergency at some point. In fact, almost a third of all adults responding to the 2017 Federal Reserve survey reported that someone in their home experienced a hardship in the previous 12 months. And most of these hardship events — like foreclosure, significant health problems, job loss, or a reduction in work hours or pay — can cost a lot of money.
The Federal Reserve’s 2017 survey found that 2016 saw more money put aside for emergencies. But their 2018 survey on economic well-being points out that in 2017, four in 10 adults still said they couldn’t cover an emergency costing $400 or more and would be forced to either borrow money or sell something to pay for the emergency.
When you face hardships without savings to draw on, your money worries are likely to be compounded by having to sell possessions or take on debt that you’ll owe interest on. And if big emergencies strike, the situation could be even worse. You could feel forced to delay medical care. You could potentially damage your credit and incur late fees if you can’t pay your bills. And you could even lose your house or car through foreclosure or repossession if you don’t make timely payments.
Setting up an emergency fund may help you better cope with whatever calamities life sends your way, because money will be sitting in your account waiting for you. You can have more peace of mind, and you may be less likely to deal with long-term financial issues, like credit card bills that you could be stuck paying long after the emergency is over.
How much should you save for an emergency?
It’s not easy to figure out how big your emergency fund should be, since you can’t know what emergencies you’ll be faced with. As of May 2018 (according to the Bureau of Labor Statistics), the median amount of time out of work after job loss was a little more than nine weeks. That fact may make you start to realize that you could be forced to rely on savings for a few months.
Now imagine that you’re already unemployed and then something terrible happens — for example, if a medical emergency for a beloved pet causes unexpected and expensive vet bills. It quickly becomes clear that an emergency fund is a safeguard that you won’t want to do without. But how much should you save?
Many financial experts recommend keeping three to six months’ worth of emergency savings tucked away, based on your monthly living expenses, including housing, food, insurance, transportation, debt payments and personal expenses. Saving enough to cover at least three months’ worth of those expenses is considered one key measure of financial preparedness, according to the Federal Reserve.
However, your emergency fund may need to be larger or smaller based on your personal situation. If you’re in an unstable job and are the sole breadwinner for a large family, having a larger emergency fund may make more sense than if you’re married with no kids and you and your spouse each make enough to cover all household bills. Being in an unsteady financial situation or having lots of people depending on you financially can drive up the amount you’ll want to have squirreled away.
How can you build up your emergency savings?
Most people probably can’t put away several months’ worth of emergency funds immediately. If that’s the case for you, don’t get discouraged. Saving as much as you can to create a starter emergency fund of around $500 to $1,000 can help protect you financially from many minor calamities.
To help build your rainy-day fund, create and live on a budget that prioritizes saving money. Track your expenses to determine what you’re spending, set spending limits to allocate where your money goes, and treat contributions to your emergency fund as a bill you have to pay. In fact, try to set up automatic contributions to your emergency savings each payday so that money moves to savings before you have a chance to spend it.
You may also have to decide how much money should go toward emergency savings versus other priorities. On-time debt payments should come first if you want to avoid potentially damaging your credit scores, and you’ll likely want to prioritize any matched retirement investments offered by your employer, so that you don’t forgo free money.
Keep in mind that you’ll probably see a variety of opinions from experts on what to prioritize, but many recommend saving for an emergency before making extra debt payments or maxing out retirement accounts, so that you don’t get trapped in a cycle of paying down debt and then using credit cards again when emergencies strike.
Where should you keep your emergency fund?
Your emergency fund should be kept separate from your checking account, so that you aren’t tempted to spend the money.
It should also be kept in an account where you can access the money easily in case of an emergency — and it should be safe from loss. You don’t want to invest your emergency fund in risky assets to try to earn higher returns. This money isn’t an investment — it’s a safety net.
High-yield bank accounts and money market accounts that pay higher interest rates than traditional savings accounts may be a good option for emergency savings. Look carefully at account requirements to find out if you’ll be charged a monthly fee, are limited in monthly transactions, or must meet requirements such as maintaining a minimum balance. You don’t want to be locked into an account with unfavorable terms that can chip away at your fund, be limited to a required account minimum amount, or be penalized if you have to withdraw your funds for an emergency.
When should you spend from emergency funds?
Once you have an emergency fund saved, the money should be used for emergencies only. Go by the basic definition of an emergency if you’re not sure whether to take money out: Are you facing an unexpected situation that requires you to act immediately?
If the expense isn’t an unexpected and necessary one and it can wait, then it’s not something that should be paid for with emergency savings. Planned home or vehicle maintenance and other expenses you know about in advance are not what emergency funds are designed for.
If you know an expense is coming, try to budget for it and save separately so that you can leave your emergency fund alone. That way it’ll be there if financial disaster strikes.
Emergency funds are essential to financial security. Investing your money in an account to cover unforeseen expenses can help you avoid taking on unnecessary debt or serious financial disasters, like foreclosure or bankruptcy, after a job loss or other setback. Start budgeting today and try to save three to six months’ worth of living expenses in a safe, accessible account so that you’re more prepared for a financial setback — it could happen sooner than you think.