Credit can be the key to trading up a better lifestyle—when you use it wisely. Credit can help you purchase the life-enhancing big-ticket items you might not otherwise be able to afford, such as a house and automobile. It's important to build and protect your credit so that it's there when you need it. Solid credit isn't built in a day, but how you use it today and tomorrow can can have far-reaching effects.
Having a cash emergency fund is an important tool to help protect your credit, as well as your overall financial well-being. When an unexpected expense crops up, having an emergency fund to draw from means you won't have to rely solely on your existing credit to pay the bill. You'll be able to shoulder the expense thanks to your dedicated emergency fund while reserving the use of your credit for the things that enhance your life and build your financial health.
The advantages of an emergency fund
Many Americans don't have any kind of savings, let alone an emergency fund. One 2016 survey found 69 percent have less than $1,000 in savings, and 34 percent have no savings at all. What's more, two-thirds would have trouble coming up with $1,000 to cover an emergency expense, according to a poll conducted by The AP.
Without an emergency fund, how would those people handle an unexpected expense? A third said they would probably borrow it from a bank, family or friends, or use a credit card to pay. Thirteen percent said they would come up with the cash by not paying other bills, and 11 percent said they probably wouldn't pay the emergency bill.
Having an emergency fund means never having to face the choice of which bill to skip or which credit card to use in order to cover an emergency expense. Being able to use cash to cover an unplanned bill means your credit is intact when you want to use it, not when you have to. What's more, it means you only pay the bill once. If you use credit to pay an emergency bill, you'll continue paying on it until the debt is repaid, and you'll pay more over time due to interest.
An emergency fund provides financial stability, emotional security and protection for your credit.
How much do you need in an emergency fund?
Besides covering an unexpected bill, an emergency fund has another critical purpose—to help cover all your expenses should you lose your job and income. For this reason, it's important to have enough in your emergency fund to cover multiple months of expenses. Experts vary on the recommended amount, but the most common advice is to have enough saved to cover three to six months of expenses.
Coming up with an estimated amount for your emergency fund is fairly easy. Simply gather all your essential monthly bills (rent or mortgage, insurance, gas for your car, food, etc.) and multiply by the number of months you expect you'll need (at least three).
To determine how many months of savings you need, consider how easy or difficult it would be for you to get another job if you were to lose yours. Would you be able to find a job quickly? Would it take more than six months? Would you be able to match or improve your current income?
What's the best kind of bank account for an emergency fund?
Store your emergency fund money in a bank account that allows you to easily access the money when you need it. However, don't make access so easy that you're tempted to dip into the funds for non-emergency purposes.
Generally, an interest-bearing savings account, checking account or money market account are the best types of accounts for emergency funds. All are liquid( meaning you can easily get money out of them without penalty), stable and FDIC insured.
It may be tempting to consider putting your emergency savings into a type of investment that will pay higher interest, such as a CD or even stocks or bonds. However, each of these has disadvantages that make them poor choices for emergency savings. CDs and bonds are not liquid, and if you withdraw money from them before they mature, you'll have to pay penalties. Stocks and other types of speculative investment vehicles are unstable, meaning you could lose money as easily as you could make it—an emergency fund isn't the right place to test out an aggressive investment strategy and have it backfire.
How to build an emergency fund
If you already have savings, good for you! You're already off on the right foot. Review the amount you have saved and decide if you can divert some of it into an emergency fund. If you're starting from scratch, a few simple steps can help you establish an emergency fund and grow it to the level you need:
- Give yourself a savings goal. Divide the total amount you want to save by the amount you feel comfortable diverting into savings every month. That's how many months it will take to reach your emergency fund goal. Breaking your goal down into monthly installments will make it more manageable.
- Find ways to divert money. Some banks have programs that allow you to round up when you pay a bill and put the rounded amount into savings. For example, if you use your checking account debit card to buy $75.29 worth of groceries, the program rounds the payment to $76 and puts the 71 cents in change into a savings account. You can do this with every bill you pay. You can also have all or a portion of your tax refund directly deposited into your emergency fund account.
- Reduce unnecessary expenses. How much do you spend each month in coffee shops, fast food restaurants or movie theaters? Review your monthly expenses to see where you can cut back on discretionary spending, then put that money directly into your emergency fund.
- Adjust investment contributions. If you're a young worker, retirement might seem incredibly far off and that you have plenty of time to save toward it. However, an emergency can crop up tomorrow. Consider diverting some (not all) of your contributions from retirement accounts toward an emergency fund. Just remember to increase those contributions again once your fund is built up.
- Earn more. You can always get a job that pays more. Or, if you're happy with the job you have, consider taking on a second part-time job just long enough to fully fund your emergency account as a helpful cushion against those unexpected expenses.
Protecting your emergency fund
It's only normal to be tempted to spend when you have a large chunk of cash saved up. Resist the temptation to spend your emergency fund money on non-emergencies, like a vacation or wedding planning. Likewise, don't dip into it to fund legitimate expenses that you could pay for through credit, like your next vehicle.
It may help to make a list of "approved" situations for tapping your emergency fund, like a home repair not covered by insurance, a vehicle repair or an unexpected medical bill. You can also limit the ways you access your fund while still keeping it liquid.
For example, if your emergency funds are stored in a checking account that comes with both printed checks and an ATM card, consider the old trick of storing your card inside a block of ice in the deep freeze of your freezer. That way, you'll either be forced to use checks to access the money or wait for the card to thaw—either way, you'll have time to think about the expense and decide if it's really an emergency.
An emergency fund is an essential tool to preserving your overall financial well-being, including the health of your credit. When you have cash on hand to handle life's crises, you can reserve your credit for the things that will make your life even better.
Editorial Disclaimer: Opinions expressed here are author's alone, not those of any bank, credit card issuer or other company, and have not been reviewed, approved or otherwise endorsed by any of these entities. All information, including rates and fees, are accurate as of the date of publication.
This article was originally published on April 20, 2017, and has been updated.