An emergency fund is an account with money saved for any mishap, setback or unexpected expense that threatens to blow a hole in your budget—such as a large medical bill, a home repair or a job loss.
Why Do I Need an Emergency Fund?
Sometimes little problems turn into big, expensive, ongoing disasters. Stocking away some money for a rainy day is the ultimate safety net, the padding that protects all your other financial goals and creates financial security. Without an emergency fund, you can end up deeper in debt or in even more dire circumstances—all because you couldn't fall back on even a small cash cushion.
57% of Americans Can't Cover a $500 Emergency Expense
According to a recent survey from Bankrate.com, 57% of Americans don't have enough cash to cover a $500 unexpected expense. And among those respondents who said they could handle a $500 crisis, 21% said they would have to put such an emergency on a credit card, while another 20% reported that they'd cut back on other expenses to come up with the cash, and 11% said they'd be forced to hit up family or friends to come up with the money.
Those are sobering numbers. The good news is that even your most modest effort to save can be enough to create an emergency fund that will get you out of the financial bumps and bruises that eventually will come up.
How Much Should I Save?
Think about it this way: $500 is $10 a week socked away in savings account for a year—enough money to cover a small car repair before it becomes a bigger breakdown that renders your ride undrivable.
Still, $500 is quite a bit less than the standard financial advice, which is to save up three- to- six months' worth of take-home pay to deal with a financial crisis. Since the Great Recession, other experts have upped their recommendation to eight months' of take-home pay.
Those are all good goals that can help you deal with a really big expense, such as losing your job and having to move out of state to find a new one. Whatever your goal, the important thing is to just start savingsomething now—even if it seems impossible.
How Do I Start an Emergency Fund?
If you don't have any kind of significant emergency savings, you'll probably want to make building this rainy-day fund your first financial priority. While you may have other objectives—paying off credit cards or student loans, buying a house, saving for retirement or even taking a vacation—the lack of an emergency fund jeopardizes all those goals.
If, for example, you decide to put all your extra money toward paying off credit card debt, what happens if you break a tooth and have to make an emergency trip to the dentist? Without cash in the bank, that expense will go on your credit card, putting you deeper in debt. Or say you start aggressively saving in a retirement fund at work.
If you run into a financial crisis, you'll end up pulling out that money, plus you'll pay taxes and penalties that will leave you with less money than if you'd simply saved the cash in your emergency fund from the get-go.
Instead, it might be a good idea to make lower payments on your debts (ensuring you cover any minimums), put your other money goals on hold for a while, forgo most luxuries, and start building your own financial safety net.
How to Build an Emergency Fund
Set up a savings account at your bank or one of the many online banks and have the money automatically deducted from your bank account every week or after every paycheck. Often times if you have direct deposit through your employer, you can also set it up so a certain percentage goes to a savings account.
You won't have to think about it, and you won't even miss the cash. But, after a few months, you will have the satisfaction of seeing your emergency fund grow from just a few dollars to several hundred, giving you a sense of success and self-sufficiency that will bolster all your other financial efforts.
You can start small, with as little as 2% of your take-home pay. For someone making $45,000 a year, that's about $12 a week after taxes. But, after just six months, you'll have more than $300, plus any interest you earn. After that, you can increase your savings rate by another 1% or 2% every year or six months, or add half of any raises that you receive. Even better—do both.
Then, look for ways to add irregular, additional deposits, whether that's half the cash left in your wallet when you get to payday, the refunds from your returnable bottles, or all the change in your purse at the end of the week. Putting a jar, small box or plastic bowl on your dresser for your spare cash helps you see your progress, and reminds you to keep adding to your fund.
Keep Your Emergency Fund Liquid
Because this is money for unexpected circumstances, you don't want to lock it up in any kind of account where you can't get to it in a day or two. That means long-term savings vehicles such as certificates of deposit, retirement accounts or savings bonds are out. You also want to avoid investments, such as stocks or mutual funds, which can lose value, usually at a time when the economy is in crisis and you could be financially vulnerable.
Instead, you want a bank savings account or money market savings account. These vehicles are government insured, highly liquid and easy to access. You won't earn a lot of interest —the best you can do these days is about 1.3% interest at the most competitive online banks—but that's not the point. The point is that you can afford the $200 for the simple repair of your water heater before it completely fails and turns into a $1,500 mess.
When Should I Use My Emergency Fund
The definition of an "emergency" never includes anything you can wrap or wear, or that requires packing suntan lotion. "FOMO"—Fear Of Missing Out—isn't ever an acceptable reason.
Obviously, losing your job is going to be the ultimate reason to turn to your emergency fund, but even then you want to take out as little as possible. Trim all your expenses, clip coupons, stop eating out and postpone any purchases you can.
Be sure to file for unemployment and do whatever you can to bring in some income such as finding a part-time job. Your goal in the case of unemployment is to stretch your emergency fund until you land new work.
In other cases where your income is steady, you'll need to use your judgment. If you need new glasses, that expense could go on a credit card if you're expecting a tax refund to pay it off in a month or two. That preserves your emergency fund in case something else comes up.
If your cell phone dies, think about putting it on a payment plan instead of drawing down your emergency fund to make an outright purchase of a new one. If you need to fly home for a family emergency, ask if there is a relative with lots of frequent-flier miles who can buy your ticket. Whenever possible, look at other options to find money or finance an expense before depleting your emergency fund.
At other times, you'll have no choice. Maybe it's a medical emergency for you, a family member or a pet. Maybe it's a repair to the car you depend on for your job, or there's damage to your home—such as a leaky roof or broken furnace. If it's something that can wait, try to save or look for alternatives.
Your bad furnace or damaged roof might be better financed with a low-interest home equity loan, for example. But, if it's urgent, necessary and unavoidable, then it's time to let your emergency fund help you out—that's why you have it!
Even in a real emergency, try to avoid completely drawing down your emergency fund to zero. Just having a little bit of cash left helps motivate you to rebuild your account, and protects you if something else bad comes along.
Once you're past your crisis, make a plan and set a deadline to restore your account and keep expanding it. After all, you've already proven to yourself how valuable it is to have cash in the bank.
Editor's Note: This post was originally published on October 5th, 2017.
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.