Many Americans do not have an emergency fund to cover an unexpected cost or loss of income. In this updated article, learn what an emergency fund is along with how to create one in 3 east steps.
An emergency fund is one of the most important parts of your financial life. It protects you when you need it most. As its name implies, it’s designed for emergencies. Many Americans rely on credit cards or short term loans to tackle unexpected expenses. Things like a last minute field trip for your daughter or a leaky roof after a bad storm.
Why You Need An Emergency Fund
Unfortunately, credit and debt have long-term implications for your finances. If you can’t pay them off right away, compound interest builds on your total amount you have to pay back. And if you make a late payment, your credit score goes down. All for a field trip.
Similarly, a job loss can be a big setback for a family. An emergency fund can supplement your income while you search for a new job. Looming bills can make you feel stressed especially while you’re trying to find more work.
An emergency fund acts as a buffer between you and long-term financial problems.
Calculating Your Emergency Fund
Use our emergency fund calculator to determine how much money you need to save. Calculate your emergency fund by using your monthly expenses and income potential to evaluate your financial health.
Emergency Fund Calculator
How much should you save in your emergency fund?
How Much To Save For An Emergency Fund
How much you need for an emergency fund depends on your personal situation. But there are some generally accepted guidelines of how much you should stash away.
How To Create an Emergency Fund in Three Easy Steps
Hopefully, this information will help you create and maintain a healthy emergency fund. But what if you don’t have an emergency fund? What if you don’t know where to start and where the extra money will come from?
We’ve outlined a three-step process on how to start an emergency:
Where Should You Keep Your Emergency Fund?
Above all else, your emergency fund should be easily accessible. Where you put your emergency fund can make a big difference though.
When you’re just getting started, the smartest thing is to start where you are. Either through an app or your existing bank. Save wherever you currently bank. Most importantly, have a separate account for your emergency fund.
Here are our recommendations on where to store your emergency fund:
High Yield Savings Account
The first and most popular option for an emergency fund is a high yield savings account. These are different than traditional savings accounts at your bank.
They impose more restrictions but give higher annual interest rates.
High yield savings accounts usually allow fewer than 6 withdrawals per month. This is perfect for an emergency fund because you likely won’t be withdrawing very often.
In many cases, there may not be a minimum balance required to open a high yield account.
Money Market Account
Although it has market in its name, money market accounts have nothing to do with the stock market. They’re actually most like a combination checking and savings account.
A money market account is a good alternative to a high yield savings account. You can still write a few checks each month and make a few withdrawals. But big transaction volume is best left to a traditional checking account.
They have similar restrictions to a high yield savings account in that they limit the number of monthly withdrawals you can make. They have higher interest rates than a regular saving or checking accounts.
Money market accounts could be a good place for your emergency fund journey. They allow you to earn a higher annual interest rate for larger sums of money.
These accounts require between $2,500 and $10,000 to get started.
The reason you’d choose a money market account over a savings account would be greater flexibility. You can easily access your money with more transactions than a savings account all while earning more interest than a checking account.
Certificates of Deposit (CDs)
You’ve probably seen or heard mentions of CDs before when talking about banking. Although common, very few people take advantage of them.
A CD could be the last step in your emergency fund journey. It offers the highest interest rates of any traditional savings option.
The catch is that you agree to lock up your money for a fixed period of time. Banks offer higher interest rates for this type of saving if they know they have your money for a while.
The periods could last anywhere from 30 days to 10 years. For the last steps of your emergency fund, a CD could make sense. You can earn the most interest on the money you’re saving in case of a job loss.
There are penalties to withdrawing early. But when combined with your other savings options, they can be the best way to maximize your returns.
Where Shouldn’t You Keep Your Emergency Fund?
Just because you have money doesn’t mean you have savings. If your money isn’t accessible in an emergency, it’s not really an emergency fund.
While these places are a good part of a financial plan, they’re not the best place to store short-term cash.
A Roth IRA is one of the most flexible investment accounts available. Unfortunately, it doesn’t offer the same type of flexibility, advantages, and protections of a savings account, money market account, or CD.
A Roth IRA is a personal investment account that lets you invest after-tax income in the stock market. You can contribute up to $6,000 per year as an individual or $12,000 as a couple.
Investing in the stock market is best as a long term strategy, not for savings.
Investing in Bonds
Bond investment is one of the safest investment vehicles you can use. Unfortunately, like a Roth IRA, they are not ideal for an emergency fund. You can diversify your investments with bonds. But they can’t replace a traditional savings strategy.
Bonds may require you to hold them until maturity for you to get your original investment back. Bonds that trade on a secondary market are subject to price fluctuation due to movements in interest rates. This means you could lose money if you need access to your cash fast. While bonds may be good for long term or more sophisticated investment strategies, they are not an ideal place for an emergency fund.
When Should You Use Your Emergency Fund?
Things have been hectic in the world lately. It seems any unexpected expense is a reason to use your emergency fund. One of the most difficult questions to answer once an emergency fund has been created is, when should you use it?
Ask yourself these 4 questions before touching your emergency fund:
Is it Urgent?
One of the most important questions with an unexpected expense is when is the bill due? If you only have a short amount of time to pay something, this could be a reason for accessing emergency funds.
If the expense is due in a few days or weeks, you now have a buffer. You can work on figuring out a different way to attack this financial problem.
Like money, time is a resource.
Is it Unexpected?
The next important question to ask yourself is; Is this truly an “unexpected” cost? For example, annual maintenance for your car is not unexpected. But replacing a timing belt on that same vehicle is most likely unplanned.
Have you ever tried to start an emergency fund? Do you currently have one?
- Tip: You can’t plan for every unexpected expense. But try to include scheduled and recommended manufacturer maintenance suggestions into your household budget. This minimizes unexpected emergencies.
Is it a Need?
An emergency fund should only be used for your needs, not wants.
Needs can also be broken down into four common categories such as:
- Medical Emergency – You need your health.
- Car or Home Repairs – You need housing and transportation.
- Loss of Employment – You need a job to pay your bills.
- Family Emergency – You need your family. Seriously.
Outside of these categories, any unexpected expenses must be scrutinized. Identify if an expense is really a need or a want.
Could You Find Money Elsewhere?
If you have time before an unexpected expense is due, take a breath. Can you find the money in other areas of your budget?
For example, if the unexpected cost is due within 30 days, you could do any of the following to help pay for it:
- Sell something you own but don’t use or want
- Find a short-term gig or project
- Do you have all or part of the expense available in your checking or savings account? What about another account?
Your personal financial strategy should help you with this last question. It’s easier to make hard decisions if you’re financially prepared.
Use Your Emergency Fund As Part of Your Overall Personal Finance Strategy
As you gain confidence in your savings and go a few months without an emergency, you can explore other savings options that can yield you better interest rates. There is nothing better than your money earning money for you!
Use these steps to prioritize your income and make sure you’re addressing your needs first: