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Unexpected expenses can throw a wrench in your financial plans, especially if you don’t have cash on hand to cover them. According to the most recent Federal Reserve analysis of household well-being, 36% of Americans say they’d be unable to cover a $400 emergency in cash.
The Covid-19 pandemic emphasized just how important it is to have cash savings in the event of a job layoff or loss, or an extended illness that prevents you from working. And even if you haven’t been affected by a job loss or illness, life could throw another financial curveball your way.
But what if you’re starting from $0 in savings? If you’re ready to create an emergency fund, this primer can help.
What Is an Emergency Fund?
An emergency fund or rainy day fund is money you set aside to cover unplanned expenses or financial emergencies. For example, you may tap into your emergency fund to pay for things like:
- Necessary home repairs, such as a leaky roof or broken HVAC system
- Unplanned car repairs
- Medical bills for an unexpected illness or injury
- Monthly expenses if you lose your job
- Unexpected veterinary bills
An emergency fund isn’t designed for nonessential spending. In other words, you wouldn’t use this money to take a vacation or buy new clothes. Instead, you’d keep this cash in reserve just in case a situation comes along where you truly need additional funds.
How Much Money Should You Have in an Emergency Fund?
When deciding how much to save for emergencies, there are some rules of thumb often recommended by financial experts.
For example, you may have heard that it’s okay to begin by saving a minimal emergency fund first, perhaps starting with $1,000. This is enough money to cover any minor emergencies that may come your way. From there, you can work your way up to saving three to six months’ worth of living expenses—or more, depending on your needs and goals.
The three-to-six-months benchmark is a good starting point; however, it’s not a foolproof rule. The Covid-19 pandemic has illustrated how having even six months’ worth of emergency savings may not be enough if you experience an extended drop in income. A Harvard University poll found that 48% of households that experienced a job loss as a result of the pandemic used up all or most of their emergency savings as a result.
When deciding how much to save in an emergency fund, consider things like:
- The number of people in your household
- The number of people in your household with income
- The amount you’d need at a minimum to cover monthly expenses
- The stability of your various income sources
The size of your emergency fund should reflect a realistic amount, based on how much you can afford to save, and be an amount that allows you to feel comfortable.
For example, instead of going by the three-to-six-months’-expenses rule, you could aim for nine to 12 months instead. Or you may choose to save a set dollar amount, such as $2,000 or $5,000, for each person in your household. Once you choose the desired amount to save for emergencies, you can move on to the next step.
Finding Money to Save for Emergencies
If you’re ready to create your emergency fund, you’ll need to find the money to save. The first step is reviewing your budget.
As you go over your budget, separate your essential versus nonessential expenses. On the essential side are things like rent or mortgage payments, utilities and food. On the nonessential side, you may have things like clothing, entertainment and dining out.
Go through the list of things you normally spend money on that aren’t actual needs and consider what you can reduce or eliminate. If you’re having trouble finding money to save, then you may need to look at your income.
Specifically, consider ways you can make more money each month. This may include taking on extra hours at work, getting a part-time job or starting a side hustle. Even selling things around the house you no longer need can help. The more money you can bring in, the more you can add to your emergency savings.
The next steps for creating an emergency fund are relatively simple. But following them can help you grow your rainy day savings with minimal headaches:
- Automate your savings. Setting up automatic transfers from checking to savings each payday, or having part of your paycheck sent to savings via direct deposit, helps remove the temptation to spend extra money in your budget.
- Save windfalls. Receiving tax refunds, economic impact payments, rebates and other unexpected financial windfalls can be a boon to your savings goals if you put them in your emergency fund, rather than spending them.
- Get cash back to save. Cash back apps can pay you back a percentage of what you spend on shopping, dining and other purchases. Signing up for one or more cash back apps, then depositing the cash you earn in savings, can help beef up your emergency fund.
- Check your tax withholding. If you typically get a refund at tax time, it may be because your employer is withholding too much from your paychecks. Adjusting your tax withholding can put more money back into your paychecks, which you could then use to grow your emergency fund throughout the year.
But what if you’ve followed all these steps and are still struggling to find money to save for emergencies? If you’re overwhelmed by debt or can’t seem to get the hang of budgeting, you may consider talking with a certified credit counselor. The National Foundation for Credit Counseling is a good place to start: Nonprofit credit counselors can review your financial situation and help you come up with a realistic game plan for creating an emergency fund.
Where to Keep Your Emergency Fund
Once you have a plan for how much to save for emergencies, it’s important to consider where you’ll keep your emergency savings. Ideally, your emergency fund should be in an account that’s easily accessible and that earns some interest. However, the amount of interest you can earn is less important than having your emergency savings readily available and not at risk in the market.
High yield savings accounts are a good option, as they can offer competitive interest rates and come with fewer fees when offered by online banks. In addition, you can link your high-yield savings account to your checking account to make transferring funds between them more manageable.
Emergency Fund Frequently Asked Questions (FAQs)
Why do I need an emergency fund?
There’s a simple reason why you need an emergency fund: to avoid debt.
If an unexpected expense comes along and you don’t have cash savings to cover it, your only options for paying for it might be charging it to a credit card or getting a loan. You’ve covered the emergency, but now you have debt to pay off, which may come with a high interest rate.
Having an emergency fund makes it easier to avoid debt—and the expensive interest charges that may come along with it.
Is a $1,000 emergency fund enough?
Saving $1,000 for emergencies is a good place to start and it’s better to have something in savings than nothing at all. But a $1,000 emergency fund will only go so far.
As you think about how much to save in an emergency fund, consider different scenarios where you might need money. These include a job loss, injury, illness or anything else that might throw your budget or income off course. Then use that as a guide for determining how much to save.
How much should I put in my emergency fund per month?
The amount you save in your emergency fund each month can depend on your savings goal. For example, say you want to save $10,000 for emergencies in the next year. You’d need to save approximately $833 a month to reach your goal.
If you already know how much you want to save and how much time you want to give yourself to reach that amount, finding a monthly savings target is simple. Just divide the dollar amount by the number of months to figure out how much to save for emergencies each month.
Should I use my emergency fund to pay off debt?
Emergency funds are designed to be used for emergencies only. But if you’re struggling with high-interest debt, you may be wondering whether it makes sense to dip into your savings to pay some of it off.
On the one hand, doing so could save you money on interest charges. And if you’re able to get rid of your debt payments and free up more money in your budget, it may not take you long to rebuild your emergency fund.
But consider how much of your emergency savings you’ll need to use and how soon you could replace them. If an unexpected cost were to come along right after you drain your emergency fund to pay off debt, you could end up having to go back into debt to cover it.
As a financial expert with extensive knowledge in personal finance and emergency fund management, I can confidently delve into the concepts covered in the provided article, providing insights and additional information to enhance your understanding.
Emergency Fund Basics: An emergency fund, often referred to as a rainy day fund, is a financial safety net set aside to cover unforeseen expenses or emergencies. The article rightly highlights the importance of having cash savings, especially in light of unexpected events like job loss, illness, or other financial curveballs.
Federal Reserve Analysis: The article mentions a Federal Reserve analysis of household well-being, citing that 36% of Americans would be unable to cover a $400 emergency in cash. This statistic underscores the widespread financial vulnerability and emphasizes the need for individuals to establish robust emergency funds.
Pandemic Impact: The Covid-19 pandemic is used as a real-world example to underscore the significance of having cash savings during economic uncertainties. The article mentions that even those with six months' worth of emergency savings faced challenges during the pandemic, highlighting the unpredictable nature of financial crises.
Determining Emergency Fund Size: The article outlines the general recommendation of saving three to six months' worth of living expenses for emergencies. However, it aptly notes that this benchmark may not be foolproof, as evidenced by the Harvard University poll showing that 48% of households with a job loss during the pandemic depleted their emergency savings.
Factors to Consider for Fund Size: Factors influencing the size of an emergency fund include household size, income sources, and monthly expenses. The article advises tailoring the fund size to individual circumstances and comfort levels. It suggests considering nine to 12 months' expenses or setting a specific dollar amount per household member, providing a personalized approach.
Creating an Emergency Fund: The article offers practical steps for creating an emergency fund, such as automating savings through direct deposit, saving windfalls like tax refunds, using cash back apps, and adjusting tax withholdings to increase monthly income.
Financial Windfalls: The concept of using unexpected financial windfalls, such as tax refunds or rebates, to bolster emergency savings is highlighted. The article encourages readers to redirect these windfalls into their emergency funds rather than spending them.
High-Yield Savings Accounts: The article suggests keeping the emergency fund in easily accessible accounts with competitive interest rates, recommending high-yield savings accounts. It emphasizes the importance of liquidity over maximizing interest earnings and recommends linking such accounts to checking accounts for convenience.
Emergency Fund FAQs: The FAQs section addresses fundamental questions about the necessity of emergency funds, the adequacy of a $1,000 fund, monthly savings targets, and the potential use of the fund to pay off debt. It emphasizes the purpose of an emergency fund in avoiding debt and provides practical considerations for determining the amount to save each month.
In conclusion, the article provides a comprehensive guide to establishing and managing an emergency fund, considering real-world scenarios and offering practical advice tailored to individual financial situations.