In this article:
Life is unpredictable. Your car may break down and require a new transmission. Or, your spouse may need medical treatment that results in a hefty bill. An emergency fund is money you set aside to cover any unexpected financial expenses that may come your way, so you can handle them without having to take out a loan or borrow money from friends and family.
How an Emergency Fund Works
An emergency fund is a simple concept: It's a pool of money you can draw from when the going gets tough. Unlike pulling money from a checking or savings account, tapping into your emergency fund should be a last resort—before turning to loans or other sources. Here's how it works:
- Set money aside in a dedicated account, preferably one that will accrue interest.
- When you are struck with a serious emergency expense, draw from your dedicated account to pay for it.
- When the dust settles, replenish the dedicated account so you're protected against future emergencies.
Why You Need an Emergency Fund
An emergency fund is a cushion that can help you absorb a blow to your pocketbook when expensive financial surprises occur—not a source of money to pull from when you want a new television.
An emergency fund can be useful in these situations:
- Unexpected medical costs: Even if you have health insurance, you may get hit with a large hospital bill that you didn't see coming. Drawing from your emergency fund can help you get through any personal or family health issues without additional stress.
- 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 may find yourself out of a job. An emergency fund can cover the repair costs so you can get back behind the wheel quickly.
- Home repairs: Depending on the issue, a home repair need can render your home unlivable. An emergency fund can help you resolve these issues before they balloon.
In short, use your emergency fund for any expense that is unexpected, urgent and absolutely necessary. Never take money out of it to pay for a vacation, buy gifts, lend money to someone or cover annual expenses.
How Much Should You Have in an Emergency Fund?
The size of your emergency fund will depend on your income, lifestyle and monthly expenses. The general rule of thumb, however, is to keep enough money in an emergency fund to cover three to six months of living expenses (rent, car payment, food, etc.).
If you are the sole earner in your household, have an irregular income or work in an industry with high turnover, you'll want to save more than someone who has a secure job or more than one source of income. There are a number of ways you can save for an emergency fund:
- Reduce your monthly expenses: Take a close look at your budget to see if you can cut back. You may find that you're paying way too much for a gym membership you rarely use and decide to cancel it. Or, you may be dishing out too much cash on lunches at restaurants and choose to pack your lunches instead. By reducing your monthly expenses, you'll have more money to put in your emergency fund.
- Sell unwanted items: Do you have clothing, electronics and other items lying around that you don't need or want? Have a garage sale or sell them online so you can stash the profits into your emergency fund.
- Pick up a side job: If you don't have a lot of money left over to allocate to your emergency fund, try to find a side job. You can babysit, deliver groceries, wait tables or do anything else that aligns with your schedule, skills and interests.
- Automate your savings: Set up 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.
- Save extra money: If you get a tax refund, money for your birthday or any other extra money, put it into your emergency fund right away.
Where to Keep Your Emergency Fund
An emergency can strike at any time, so it's a good idea to keep it in an account that you can access quickly. The account should be separate from the bank account you use on a regular basis so that you're less tempted to use your funds for non-emergency purposes like a vacation or fancy dinner out. Here are some places you may want to consider keeping your emergency fund.
- High-yield savings account: A high-yield savings account offers a particularly high interest rate or yield. You can open one at a credit union, online bank or a brick-and-mortar bank. While standard savings accounts typically offer interest rates of under 1%, you may be able to find a high-yield savings account with an interest rate of 2% or more. A $10,000 emergency fund in a 2% interest rate account, for example, would earn $200 annually.
- 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. It differs from a high-yield savings account because it often comes with a monthly minimum balance requirements and maintenance fees.
- Treasury bill: A Treasury bill, or T-bill, is backed by the U.S. Department of the Treasury and sold in $1,000 increments. You can purchase one from the Treasury's TreasuryDirect site, a broker or a bank. Once the T-bill you buy at less than face value matures in about a year or less, you can sell it at its face value and keep the profit. T-bill yields can fluctuate, so look over current rates to see if this route will give much of a return.
- Certificate of deposit (CD): With a CD, you can land a higher interest rate than you may be able to with a high-yield savings or money market account—but you will have to pay a fee if you withdraw your money before the end of the CD's term. If you go this route, consider creating a CD ladder. A CD ladder is when you purchase CDs with different terms so you can access some of your money without having to lose the interest you've earned.
The Bottom Line
An emergency fund can provide you with the peace of mind of knowing that when an emergency situation arises, you can focus on dealing with it, rather than stressing about your finances. It can also help you stay out of debt and achieve your financial goals.