5 Steps to Build an Emergency Fund

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Emergencies happen. A loss of income, an unexpected medical bill, an urgent car or home repair—it's the stuff of life. But each of these can be extremely stressful and damaging to your financial health when you don't have the cash to make it through.

That's why having an emergency fund—money set aside specifically to cover your needs in the event of a crisis—is key to financial success. Not only can it help you stay afloat when the unexpected happens, but there's also a psychological benefit to knowing you'll be able to survive in an emergency without going into debt. Here's how to build an emergency fund in five steps.

1. Create a Budget

Before you set savings goals and begin funding your emergency fund, you'll need to take a look at how you're spending money now. Tracking your spending and starting a budget will help you set savings goal posts—more on this below. Even more fundamentally, a budget will help you direct your spending toward your goal.

A budget is a plan for your money that takes into account how much cash you have coming in, your necessary expenses, how much you plan to spend and, importantly, how much you'll save. Starting a budget with establishing an emergency fund in mind will help you come up with a saving baseline that works for you.

2. Set Savings Goals

The next step to creating an emergency fund is to create concrete, reachable goals. Experts suggest aiming to keep anywhere from three to six months' worth of expenses in an account you can access easily, such as a high-yield savings account. You may aim to save more than that, depending on individual factors, like having a variable income.

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When setting your emergency savings goals, keep in mind that you should look at your bare-bones expenses, rather than your usual spending. That's because, when you aren't in emergency mode, you're likely spending on a variety of goods and services, both necessary and unnecessary. But in a true emergency, you'll dial back your spending to just the essentials and limit discretionary spending. Don't include things like retail, dining and entertainment in your goal number. Instead, tally up what you spend on housing, utilities, basic food, care for children and pets, transportation and the like.

Last, make sure you set a goal that doesn't feel too hard to reach. Six months' worth of expenses is a lot of money, which can be discouraging. But the key is to start where you're at. Take inspiration from these small goals, and tweak them to fit your situation:

  • Save $100 by the end of the month.
  • Save $1,000 by the end of the year.
  • Save one month's worth of basic expenses by the middle of next year.

Once you reach that first goal, you'll have a springboard that can motivate you to reach a larger savings goal next.

3. Automate Your Savings

It's a savings truth universally acknowledged: If you don't pay yourself first, you likely won't pay yourself at all. In other words, make sure your savings is automatically transferred from your checking account to your savings on payday. Otherwise, you may find that after covering your expenses and doing some spending, you haven't enough left to save.

How much should you put away from each paycheck? The answer depends on your personal financial picture, but the key is to be consistent. So, if you can afford to transfer $200 each paycheck into your emergency fund, then that may be a good number for you. If you can only afford a smaller amount, such as $50, start there.

You may be able to set up a split deposit through your employer's payroll, which will allow you to automatically route a portion of your paycheck directly into savings. If it's money you never see, you won't be tempted to spend it.

4. Look for More Money to Save

As you get into the habit of saving more and spending less, you may be able to up your contributions to your emergency fund over time. Take into account all your savings goals when calculating how much you can set aside for emergency savings.

One rule of thumb is to save around 20% of your gross income. That number typically includes your retirement contributions as well as other savings goals, such as money for a down payment on a car or home and your emergency fund.

On top of upping your savings ratio gradually, take advantage of any windfalls you receive by funneling them directly into your emergency fund. If you receive a tax refund or a holiday bonus, for example, put it into your emergency fund. Is it the most exciting use for unexpected cash? Perhaps not, but you'll reach your goal for increased financial well-being faster.

5. Keep Your Emergency Fund Liquid

As you increase the balance in your savings account, you may be tempted to invest those funds. But it's wise to keep your emergency fund liquid, rather than tied up in investments.

While investing your money can bring higher returns, it can also come with losses, especially if you have to sell quickly in the event of an emergency. That probably isn't worth the risk.

Instead, keep your emergency fund in a liquid account, such as a high-yield savings account, where it will yield higher interest than the average savings account does but still be available for withdrawal in the event that you need it.

Keep Calm and Save Money

Once you establish your emergency fund and build up reserves of at least three months, you're on track to increased financial stability. You can give yourself a pat on the back—and then keep saving.

Beyond establishing an emergency fund, come up with long-term financial goals. You might want to save for a down payment on a house, invest in equity-boosting home improvements or achieve retirement savings goals.