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An emergency fund is a savings account you can tap into when unexpected expenses or costly financial surprises arise. Having a flush emergency budget can help you handle a crisis without having to take out a loan or borrow money from friends or family.
Unlike pulling money from a checking or savings account, tapping into your emergency fund should be reserved for times of serious need. Here's what an emergency fund is and how you can start one.
What Is an Emergency Fund?
An unexpected expense can strike at any time. Your car may break down and require a new transmission, or you may need expensive medical treatment.
That's where an emergency fund comes in. An emergency fund is a pool of money you can draw from to cover surprise expenses and emergencies. Your emergency savings should be separate from the bank accounts you use for regular financial transactions and only used when you can't easily pay for an unexpected expense. It's a proactive way to set yourself up for less financial stress and greater security.
Why You Need an Emergency Fund
You need an emergency fund to avoid relying on debt and to minimize long-term financial impacts when you're hit with a crisis.
Here are some common financial crises that an emergency fund can help cover:
- Unexpected medical costs: Even if you have health insurance, you may get hit with a large hospital bill you didn't see coming. Or you may need to pay for a medical procedure that your insurance only partially covers, or doesn't cover at all.
- Job loss: If you suddenly lose your job, an emergency fund can help you cover bills until you find a new one.
- Car repairs: You may rely on your car to get to work every day. If it breaks down, you could find yourself out of a job.
- Home repairs and other costs: A leaky roof, broken refrigerator or other home emergency can make living in your house difficult or even impossible.
In short, use your emergency fund for any expense that is unexpected, urgent and absolutely necessary. Avoid taking money out of it to pay for a vacation, buy gifts, lend money to someone or cover annual expenses—a sinking fund would be a better choice in these cases.
How Much Money Should You Have in an Emergency Fund?
The size of your emergency fund may depend on your income and expenses. In general, experts suggest stashing enough money in your emergency fund to cover three to six months of living expenses (including rent or mortgage, car payment, food, utilities and the like).
If you're the sole earner in your household, or if you have an irregular income or work as a freelancer, you might aim to save more.
Where to Keep Your Emergency Fund
Keep your emergency fund separate from the bank account you use on a regular basis. If you keep your savings in your checking account, you may be tempted to use your funds for non-emergency purposes like a new television or a fancy dinner out.
Because an emergency can strike at any time, it's a good idea to keep your emergency fund in an account that you can access quickly. Here are some options to consider.
Interest-Bearing Bank Accounts
The best place to keep your emergency fund is an account where you'll be able to access your funds at a moment's notice while also earning as much interest as possible. These are the best options:
- High-yield savings account: A high-yield savings account can help you earn more on your emergency savings. You can open one at a credit union, an online bank or a brick-and-mortar bank. While the national average annual percent yield (APY) for a savings account is 0.08% as of mid-2022, a high-yield savings account can earn as much as 1.26% in interest.
- Money market account: A money market account also offers higher interest rates than standard savings accounts and is offered at most banks and credit unions. They differ from high-yield savings accounts in that they typically provide check-writing privileges and may require a higher initial deposit and ongoing minimum balance.
Some people choose to invest a portion of their emergency savings in short-term investing options.
Assets like Treasury securities and certificates of deposit (CDs) may earn slightly more interest than a savings account, but be cautious if you're considering investing your emergency fund in one of them. You may be charged early-withdrawal penalties if you need your funds at the drop of a hat. And while bond laddering may help you structure some liquidity in your strategy, since you can't predict when you'll be hit with an emergency, some risk remains.
Instead, leave most if not all your emergency savings in a more liquid account and develop a different plan for investing funds you don't depend on for instant access.
How to Build an Emergency Fund
Typically, the best way to build an emergency fund is to begin automatically directing a portion of each paycheck into your emergency savings. However, this can be a challenge if you have an irregular income or a tight budget, and you may have to modify the steps below to tailor them to budgeting with an irregular income.
Here are basic steps to follow to build your emergency fund:
1. Set a Goal
Decide how much money you want in your emergency fund. If you're building your emergency fund from scratch, set an initial goal that feels attainable rather than daunting, such as $1,000. You can also calculate your monthly expenses and start your saving journey by aiming to save one or two months' expenses. Once you hit that milestone, set new goals until you build your savings up to a comfortable point.
2. Create a Budget
Now that you have a goal, you'll need to devise a plan for how you'll get there. Budgeting for savings is key to meeting your goal. If you don't already have a budget that you can stick with and one that includes your savings goal as a top priority, you can create a budget now.
3. Find Funds
If in creating your budget you find that you don't have much money left to allocate to your emergency fund, look for places to cut back spending.
Canceling unneeded subscriptions or an unused gym membership, cooking more meals at home and negotiating your bills can help you reduce your expenses. You might also consider starting a side hustle or selling unwanted items.
Lastly, grow your emergency fund faster by funneling windfalls into savings. If you get a tax refund, money for your birthday or any other extra money, add it to your emergency fund.
4. Set Up Automatic Savings
Establish a recurring automatic transfer from your checking account to your emergency fund account to occur every time you get paid. This way, you won't forget to contribute to your emergency fund.
You can set up automatic transfers through your bank. And some employers offer emergency savings accounts that make automatically deducting your emergency savings simple.
5. Monitor Your Progress
Check your savings balance regularly, such as each payday, to ensure your deposits are accurate and celebrate your progress.
Avoid tapping into funds except in the case of a true emergency. When you do use your emergency savings, make a plan for replenishing the funds once the crisis is in the rearview.
The Bottom Line
An emergency fund is a route to increased financial security and decreased reliance on borrowing. On top of that, having ample savings can give you real peace of mind to know that you're covered in a crisis.
Apart from the financial and psychological benefits of having funds budgeted for emergencies, getting in the habit of creating savings goals and making savings automatic is a strong way to improve your financial life overall. Once you have a sturdy emergency fund in the bank, apply the same approach to nailing other savings goals, such as saving for a down payment on a house.