What Is An Emergency Fund?

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Contributor, Benzinga
May 14, 2024

An emergency fund is your safety net during unexpected events. Aim to have a savings equivalent to three to six months' worth of expenses in your emergency fund.

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Life is a rollercoaster of unexpected surprises, some positive and some not so positive. While we can plan and budget for most expenses, there are certain events in life that require immediate financial attention. Whether it’s a medical emergency, a car repair, or a sudden job loss, having extra funds on hand can make a huge difference in how smoothly you can navigate these unforeseen circumstances. This is where having an emergency fund comes into play. In this article, we will explore what an emergency fund is, why it is important, and how you can start building one to protect yourself against unforeseen circumstances.

What Is an Emergency Fund?

An emergency fund is an essential financial tool that everyone should have. Simply put, an emergency fund is a stash of money set aside to cover unexpected expenses or financial emergencies. These could include things like medical bills, car repairs, job loss or any other unforeseen event that may require a significant amount of money. Emergency funds are only for emergencies. They are not for everyday expenses.

Why an Emergency Fund Is Important

Having an emergency fund is essential because it provides a financial safety net in case of unexpected expenses or income loss. This fund can help cover essential expenses and prevent you from going into debt during unforeseen circumstances such as medical emergencies, job loss or car repairs. Having an emergency fund savings gives you peace of mind and the ability to weather financial hardships without derailing your long-term financial goals.

How Much Should Be Your Emergency Fund?

Financial experts typically recommend having anywhere from three to six months' worth of living expenses saved in your emergency fund. This amount can vary depending on individual circumstances such as income stability, monthly expenses, and debt levels.

This may seem like a difficult task, especially if you are just starting out or are living paycheck to paycheck. However, the key is to start small and be consistent. Set a realistic goal for how much you want to save each week or month, and make it a priority to set that money aside.

Consider adjusting your savings goal based on your individual factors. If you have higher monthly expenses, dependents, or a less stable job, you may want to aim for the higher end of the three to six-month range. On the other hand, if you have lower expenses and more job security, you may be able to get by with a smaller emergency fund.

If your expenses increase or your income decreases, you may need to save more to ensure you have an adequate safety net. Likewise, if your financial situation improves, you may be able to reduce your savings goal or reallocate those funds to other financial goals.

Where Should You Keep Your Emergency Fund?

You have to work hard to build an emergency fund and stay disciplined, but where should you put that money? It is recommended to keep your emergency fund in a savings account that earns high interest and is easily accessible in case of emergencies. Avoid investing it in risky assets or tying it up in long-term investments that may be hard to liquidate quickly. Here are the best places to keep your emergency fund.

  • High-yield savings account: A high-yield savings account combines high interest rates with accessibility. You can make up to six withdrawals each month and earn interest on your money. You should compare high-yield savings accounts from several banks and credit unions to see which ones offer the best rates.
  • Money market account: A money market account has a slightly higher interest rate than a regular savings account. Most of these accounts come with check-writing privileges that can make it easier to cover an emergency. You get to earn interest on your money while letting it sit in your account. You may have to make a high minimum deposit to open the account.
  • Certificate of Deposit (CD): A certificate of deposit offers higher returns than high-yield savings accounts and money market accounts, with the possibility of exceeding 5% APY. However, funds in CDs are less accessible until the maturity date, at which point the consumer can choose to receive the funds plus accumulated interest or transfer them into a checking account. Some people use a CD ladder strategy to increase access to cash while still earning higher interest rates.
  • Online savings account: Online banks tend to have higher interest rates for their savings accounts since they have less overhead. Some of these savings accounts have similar rates as CDs and offer risk-free returns. You should only do business with an online bank insured by the Federal Deposit Insurance Corporation (FDIC) and compare options before putting your money into one of these banks. Keeping your emergency funds in these banks and making them less accessible can keep your funds safe from discretionary purchases.
  • Cash or checking account: While a cash position or checking account isn’t the best place to store emergency funds because of low or no interest rates, some of your funds should be easily accessible. With cash or a checking account, you won’t have to wait for a CD to mature before accessing cash. You should only keep a small amount of your emergency funds as cash or in a checking account.

How to Build an Emergency Fund Easily

Consumers can implement several strategies to build up their emergency funds. Here are some ways to get started and build your emergency fund.

1. Set a Financial Goal

Creating a financial goal lets you start with the end in mind. You should consider how many months of living expenses you want in your emergency savings account in case you get laid off or a large expense comes up. Most people aim for 3 to 6 months’ worth of living expenses in an emergency fund, but some people stretch it to 12 to 18 months.

While it would be nice to have 18 months’ worth of living expenses in an emergency savings account, you have to review all your finances to determine if it is realistic. Setting an unrealistic goal can leave you feeling discouraged. It’s better to start off with small wins, like saving up three months’ worth of living expenses, before venturing to larger goals.

2. Create a Budget

A budget helps you keep your expenses in check. Consumers can review their bank and credit card statements to see where their money goes and tighten their spending. If you have never looked at your budget and individual expenses, this step can save you a lot of money. You can then put that money into your emergency fund.

3. Start Small and Be Consistent

Financial goals take a long time to achieve. Some goals require a multi-year horizon, but you reach those goals with a series of small steps. Instead of looking at the gap between where you are and where you want to be, focus on what you can do this week to get closer to your goal. Giving yourself smaller deadlines allows you to build consistency and make progress toward your emergency funds goal. 

You can also automate some of your savings through automatic transactions. You can set a weekly transfer from your checking account to your emergency fund. These automatic transfers increase the likelihood of success since you don’t have to manually transfer money into your emergency fund each week. You don’t have to worry about forgetting if you enable automatic transfers. 

4. Reduce Non-Essential Spending

When you track your expenses, it becomes easier to detect discretionary spending and question it in real time. You can cut back on non-essential spending without eliminating it entirely. Instead of dining out once every two weeks, you can consider dining out once per month. Entertainment also presents an opportunity to save, as there are many free ways to have a fun time. It’s possible to get movies at the library or wait for movies in the cinemas to come out as DVDs to save money. 

Some non-essential expenses happen automatically and are easy to overlook. Monthly subscriptions continue accruing on credit cards regardless of whether people use those services or not. Some people pay for gym memberships and streaming subscriptions even if they use neither of those services. Think carefully about every expense and ask yourself if it is necessary. Trimming down on expenses now will help you build an emergency savings account for future surprises. 

5. Increase Income

Reviewing your budget and trimming expenses give you quick wins on the path to achieving your financial goals. Simultaneously growing your income will yield the quickest growth, especially when you significantly trim your budget and have very few expenses you could still cut.

You can pick up side hustles and freelance clients or sell extra stuff around the house to make extra income. While these strategies work, consumers should also look for career advancement opportunities. Leveling up in your career can open the door to better opportunities and higher pay in the future. 

6. Keep Track of Progress

Tracking something increases the likelihood of improving. Monitoring your emergency savings account and tracking how much it grows each month can help you gauge if you are on the right course. It also serves as inspiration and can make you consider increasing the monthly contribution to your emergency fund.

7. Protect Your Funds

You can dine out and go on vacations while building up your emergency savings account. However, you cannot tap into that fund for non-essentials. The emergency fund is specifically for emergencies that you cannot anticipate. If you avoid draining your funds on unnecessary purchases, you give yourself a greater financial buffer for a surprise.

8. Revisit and Adjust

Financial goals adjust as consumers navigate new challenges, grow their income, and change their priorities. It’s a good idea to periodically reassess your savings goals and financial situation. If your income has expanded and expenses have stayed the same, it may make sense to increase your monthly contribution. You should modify your goals based on changes to your income and expenses.

Save Up for Any Emergency

An emergency fund is a valuable resource that can ease financial stress and prepare you for any surprise expense. Setting small goals will make the journey more enjoyable and increase the likelihood of success. You don’t know when an emergency will arise, but it’s better to be ready for it than scrambling to get a loan.