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An emergency fund is an important part of every adult's life. Not only will it help you make ends meet when times are tough, it can also provide peace of mind when times are stable. Setting up an emergency fund can help you weather financial storms without panicking, forgoing or borrowing.
Not all cash flow problems are true emergencies, however, and unnecessarily tapping into the funds you've saved can leave you high and dry when critical needs arise. So before making a withdrawal, consider how to best use your emergency fund.
When to Use Your Emergency Fund
True financial emergencies need to pass a two-pronged test:
- Consequences: Your life will be significantly disrupted if you don't spend the money.
- Urgency: Time is of the essence, so you can't afford to wait and save for what you need.
Common reasons to tap into an emergency fund include:
- Job loss: Without an income you won't be able to meet your living expenses, but an emergency fund can come to the rescue. As you're seeking and securing a new job, you can use the money you have set aside to pay your bills.
- Medical or dental expenses: Unanticipated health care costs can cause serious debt. According to a 2019 survey conducted by the Kaiser Family Foundation, the average deductible on employer-provided health care plans is $1,655. Having enough cash available to pay such a sum can help you avoid taking on high interest credit card or loan debt.
- Pet care: When beloved pets need costly veterinary services, you may choose to use the money from your emergency account to cover their care.
- Home needs: When your roof, water heater or plumbing system breaks down and needs replacing, the cost to do so can easily exceed what wiggle room you have in your monthly budget. To prevent further damage to your home making repairs even costlier, an emergency fund can be your safety net.
- Car repairs: As vehicles age, repairs will be necessary. It's best to factor things like tires and tuneups into your monthly budget, but unexpected major repairs may require you to tap the money in your emergency fund—especially if you rely on your vehicle to get to work.
- Children's needs: Your first-grader suddenly outgrows their car seat or your teenager's laptop breaks and needs to be replaced. Whatever the case, children are expensive and unexpected costs do come up. The funds in that emergency account can protect them and you.
- Technology replacement: You dropped your cellphone in a sink full of water and need the device for work. You can't exactly go without a cellphone, and your emergency fund may be able to cover a replacement.
- Essential travel: If a loved one falls ill, you may need to jump on a plane to be at their bedside. Last minute travel can cost plenty, but cash from your emergency fund can help you avoid coming up short.
How Much Should I Have in My Emergency Fund?
Clearly, a host of unanticipated costs can come your way and it's not possible to know for sure which may be in your future. With that in mind, however, a savvy way to determine the amount you'll need to save is to use your living expenses as a guide.
A good rule of thumb is to have enough money set aside to cover three to six months' worth of living expenses. The more people you have depending on you, the more you should save for emergencies.
Examine your budget. List all of those expenses that absolutely must be covered every month. These typically include:
- Mortgage or rent
Add them up and then multiply that figure by three. That would equal three months' worth of necessary expenses, which would cover you and those in your care in case you lost your job.
As an example, let's say you need a minimum of $1,500 to keep your household running each month. If there is an interruption in your income, an emergency fund of at least $4,500 ($1,500 x 3) will protect you for three months.
Whenever you tap your emergency fund, be sure to return the money as soon as you can. If you have a sudden windfall, you may want to increase the amount of money in your fund to a figure that feels more comfortable. Even if it takes you beyond six months' worth of income, it doesn't hurt to add additional funds as a just-in-case measure.
Where to Keep Your Emergency Fund
It's best to keep your emergency fund within reach, but this doesn't mean to stuff it under your mattress. Your fund should be easily accessible without being too available to spend or intermingled with other money. A checking account is the worst place to maintain emergency savings because the money will get muddled with all your other expenses.
Your best options for an emergency fund are:
- High-yield savings account: Look for a savings account at a financial institution that's separate from your checking account. Look for one with a higher interest rate (yield) than your bank offers. The higher the rate, the more money your savings will generate: $10,000 in a savings account offering a 2% interest rate would earn $200 annually—enough to pay for an unexpected vet bill.
- Money market account: Banks and credit unions offer money market accounts, which also give higher interest rates than standard savings accounts. They do expect a monthly minimum balance (making it less tempting to dig into if you don't have to) and maintenance fees.
- Certificate of deposit (CD): CDs, which are low-risk investment products offered by financial institutions and brokerages, can also be good for emergency accounts because their interest rates can be much higher than other savings vehicles. You will have to keep the money invested for a term or be subject to a fee for an early withdrawal, To avoid the fee, you can create a CD ladder that allows you to purchase CDs with varying terms.
A simple way to amass an emergency fund is to have a fixed amount of money deducted from your checking account and deposited automatically into the savings account of your choosing. When you have enough to invest, you can pursue other short-term savings options.
Wherever you put your money, don't stop saving until you reach your desired amount. When you hit your personal threshold, you can apply the extra funds to your other goals. Building an emergency fund is one of the most adult things you will ever do—and you'll always be grateful that you did.