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As the name suggests, an emergency fund is a stash of money set aside to cover living expenses in case of an emergency like a job loss, unexpected medical need or last-minute car repair. But how much money you should have in that fund depends on your income and your financial obligations, especially basics such as rent, utilities and food.
Your emergency fund should be used only as a last resort for real emergencies, once other strategies such as reducing your expenses have been exhausted. Making that commitment will mean you'll have access to this money when you truly need it, something you'll be grateful for.
What Is an Emergency Fund?
An emergency fund can help you get through a tough financial time without taking out a loan, accumulating charges on your credit cards or borrowing money from family and friends.
Your emergency fund should be separate from your regular checking and savings accounts, and it should be filled with money only for emergencies. It's best to put your emergency money in an account that earns interest instead of stuffing it under your mattress.
If an emergency such as job loss unfortunately arises, you can pull money from the fund to make sure you can keep a roof over your head, stock up the refrigerator and make all your bill payments on time. Since an emergency fund doesn't need to be paid back with interest, it's usually the wiser choice over other potentially costly methods of borrowing money, such as withdrawing money from a retirement account, using a personal loan or relying on your credit cards.
Once you've made it through an emergency, you can start contributing again to your emergency fund to prepare for the next unexpected event.
How Much Should You Have in Your Emergency Fund?
When it comes to deciding how much to keep in your emergency fund, there's no one-size-fits-all approach. But a good rule of thumb is to set aside enough money to cover three to six months' worth of living expenses, including rent or mortgage payments, grocery bills and car payments.
Let's say your monthly living expenses add up to $2,800. When you apply the three- to six-month rule, your emergency fund would be $8,400 to $16,800.
If you work in an economically volatile industry, you are the only one in your household who's bringing home the bacon or your income fluctuates from month to month, consider going beyond the three- to six-month guideline if possible. Setting aside this much money—or even just three months' worth of expenses—may be difficult or even impossible in your situation. In that case, comb your budget for places you can cut back (more on this below), and put whatever extra savings you can find into your emergency fund. Even saving one month's expenses is better than having no emergency savings.
When deciding how much money to keep in your emergency fund, go over some of the surprise expenses that may come up in your life. Obviously it's impossible to predict the future, but here are some common expenses you could prepare for:
- Medical expenses: Even if you have health insurance, medical costs from copays, deductibles and other fees can quickly add up. A Kaiser Family Foundation study put the average deductible (the amount you'll pay before insurance kicks in) on employer-provided health plans at $1,655.
- Car repairs: Car troubles can quickly snowball into further difficulties such as job loss, so being able to get your vehicle in driving shape again quickly will pay off. Parts and labor for replacement of your car's transmission, for example, can cost $1,500 to $3,000.
- Job loss: Losing your livelihood can cause major financial stress, but with the proper preparation you can minimize that harm it wreaks.
- Home repairs: Home repairs may seem like a cost that's easy to put off, but a broken air conditioner in a region with hot summers can be downright dangerous. One estimate shows replacing your air conditioner can range from $2,426 to $8,900.
How to Build an Emergency Fund
Once you know how much money you should have in your emergency fund, it's time to start building it. There are a number of strategies you can use to build up your reserve, but they'll ultimately come down to what you're comfortable with given your financial situation.
Building an emergency fund is something you can do without any outside help from a professional accountant or financial planner. Here's how to get started:
Set a Realistic Budget
Starting an emergency fund begins with setting a budget. Calculate your monthly income and expenses: How much money is coming in and how much is going out?
A spreadsheet or a budget app can serve as the foundation for your plan, enabling you to carefully track your spending and stay on top of how much money you can carve out for your emergency fund.
Once you've done the math, look at how much money is left after taking care of basic living expenses, credit card bills, loan payments and so forth. Does the math indicate you're basically living paycheck to paycheck? If so, it's time to find ways to cut costs:
- Tackle your credit card debt. When you reduce or eliminate that debt, you can free up money for the emergency fund. Paying down your credit cards can also help you raise your credit scores.
- Decrease discretionary spending. This is spending on things other than the necessities, such as your gym membership or entertainment. Look at where you could stand to cut back here, and put this "found" money toward your emergency fund.
- Find ways to reduce your bills. Making a call to your cellphone provider, insurance agent and other businesses you make payments to every month can sometimes result in savings if you simply ask. Some companies can provide special rates for customers who call to cancel an account, for instance.
Establish Your Monthly Savings Goal
Once you know how much you'd like to have in your emergency fund, you can start constructing a savings timeline.
If you plan to build your emergency fund month by month, it's key to plan out how much you'll be depositing with a savings goal. Allocating money for your emergency fund on a monthly basis can simplify the task and help you stay committed to building up your fund.
Before shifting money to your emergency fund, though, make sure you hang on to enough money to cover your everyday living expenses. An emergency fund is important, but you should never jeopardize your existing necessities for the sake of making deposits to one.
Find a Safe Place for Your Money
Your piggy bank may be cute, but it's not the prettiest place for your emergency fund.
Placing your emergency fund in an account with a bank, credit union or other financial institution will not only keep your money safe, but may earn you cash in interest as well. A few options to consider include:
- High-yield savings account: These accounts offered through banks and credit unions can offer interest yields of 1% to 2% per year. You can take money out like you would a regular bank account, but will likely be limited in how many withdrawals you can make per month.
- Money market account: Money market accounts are similar to high-yield saving accounts, but can net you a higher interest rate. Unlike high-yield savings accounts, however, money market accounts may require a large deposit to open them and a minimum balance to keep them open.
- Certificates of deposit (CD): CD accounts are another way to earn interest on your savings, but you'll be limited in how much access you have to the cash. You may be charged a penalty for withdrawing from it before a predetermined date.
Whichever savings method you choose should be reserved for your emergency fund and not intermingled with savings for retirement or other plans, and should be free of any withdrawal penalties or procedures that would delay your receipt of the money or diminish the amount you'll get back.
Find High-Yield Savings Accounts
Keep Your Money in an Unconnected Account
Putting your emergency money in an account that's directly tied to your checking account might seduce you into quick and easy "borrowing" from your emergency fund. Instead, you might try a more hands-off approach. Housing your emergency fund at a different bank or credit union might make it harder to transfer money from the emergency fund to your checking account.
Automatically Transfer Your Money
The "set it and forget it" method can pay off. By setting up automatic transfers from your bank account to your emergency fund, you won't need to think about making those deposits. You might even look into a direct-deposit arrangement, allowing you to automatically steer a portion of your paycheck to your emergency fund.
The Bottom Line
An emergency fund can be a lifeline when you confront unexpected circumstances, allowing you to have a place to live, put food on the table, pay utility bills and keep pace with credit card and loan payments.
Establishing an emergency fund can be one of the best gifts you can give your future self. And it can be simple to do, as long as you put together a budget, watch your spending and stick to your savings goal.