Why you need an emergency fund and a step-by-step guide to getting started.
Many people are very nervous with everything going on in the U.S. and world economy—daily news updates on bank runs, poor market returns, decreasing dollar values, and the latest round of layoffs. In times like these, the importance of an emergency fund cannot be overstated. (For a video summary of this article, watch the Youtube Live replay.)
What Is an Emergency Fund?
Having an emergency fund means setting aside a sum of money that is easily (i.e. quickly) accessible and designated solely for unexpected expenses. These expenses could be related to a variety of situations, such as a sudden job loss, medical emergency, or car repair.
A general rule of thumb is that you should have 3 to 6 months of your living expenses available in case of emergency. The amount of cash one should hold can vary depending on your lifestyle and immediate and long-term liquidity needs.
Emergency Funds Are a Backstop to Multiple Financial Problems
Emergency funds are a valuable tool for managing multiple financial problems.
Avoid the Cycle-of-Debt
By having an emergency fund, you can avoid taking on debt or having to dip into other savings, such as retirement accounts or long-term savings, to cover these unexpected expenses. An emergency fund helps you stay on track with your financial goals and avoid the stress and financial burden of unexpected costs.
Often, when we have an insufficient rainy-day fund and an unexpected emergency happens (major home repair, medical bill, car breakdown, job loss, etc.), our lack of financial resources severely limits viable solutions and we are forced to borrow money at high-interest rates to cover the expense. Additionally, not having the financial means to cover the need adds to an already stressful event. Planning ahead and bolstering your cash holdings will enable you to calmly evaluate the situation and decide how best to proceed without the additional emotional stress of lacking the financial resources to address the problem.
While a short-term loan may offer respite during a financial emergency, its interest rate isn’t the only expense to consider. The loan payment will also affect your monthly cash flow, which will have to accommodate the repayment of the loan. Consequently, you’ll need to redirect your cash flow towards paying off the loan rather than setting aside funds for an emergency.
Depending on life events, this cycle often continues indefinitely making you feel like you will never catch up.
Break this cycle now, by making a plan to pay off all high interest debt AND setting aside money each month into an emergency fund. This may require a significant reduction in spending—particularly in the short-term—but it is mandatory for your financial health.
Give You Peace of Mind
Having an emergency fund can provide a sense of financial security and peace of mind. Knowing that you have a cushion to fall back on in case of an emergency can reduce financial anxiety and allow you to focus on other aspects of your financial plan and life. Here are just a few financial aspects you could refocus on once you have established a sufficient emergency fund:
Retirement planning: Having an emergency fund means you can direct more funds towards retirement savings, such as contributing to a 401(k) or a Roth IRA.
Debt reduction: With an emergency fund soundly established, you can focus on paying off high-interest debts, such as credit card balances or personal loans, which can help you save money on interest payments in the long run. In the future, your emergency fund will avert any need to accumulate high-interest debts to combat financial emergencies.
Saving for known major expenses or goals: If you have upcoming major expenses, such as a down payment for a home or a child’s college tuition, you can use your emergency fund to cover unexpected costs that may arise, freeing up more of your income to save for those expenses.
Overall, having an emergency fund is a wise financial decision that can help you manage multiple financial problems and protect your financial stability.
How Much Cash Do You Need
The amount of cash one should hold varies depending on your lifestyle and immediate and long-term needs. However, below are some general rules of thumb:
Emergency Fund – 3 months of expenses
If you have very stable employment that is unlikely to be affected by a market correction, industry upheaval, or recession, plan to keep at least three months of your living expenses in cash for emergencies.
Emergency Fund – 6 months to 1 year of expenses
If your employment is less predictable—perhaps you are self-employed, work on commission, or are worried about other negative factors that could impact your employment—plan to keep at least six months to one year’s worth of cash for emergencies.
Emergency Fund – Retired/Living on Your Investments
If your main source of income in retirement is reliant on your liquid investments, consider holding at least 1–2 years’ worth of living expenses in cash. These monies can be utilized for emergencies and also as a “sinking fund” for if and when there are market downturns that make it less favorable to sell positions in your investments.
How To Build Your Emergency Fund
When establishing your emergency fund, slow and steady wins the race. Here are some steps to follow to build an emergency fund:
Determine your emergency fund goal: To begin, you should determine how much money you need to save for your emergency fund. A good rule of thumb is to save 3-6 months’ worth of living expenses.
Analyze your monthly budget: Evaluate your monthly expenses and find areas where you can cut back on spending. Consider things like dining out, entertainment expenses, and subscription services.
Make a plan to save: Create a savings plan that will help you reach your emergency fund goal. Set aside a specific amount of money each month to put towards your emergency fund, and make it a priority.
Automate your savings: Set up an automatic transfer from your checking account to your emergency fund savings account. This way, you won’t have to remember to make the transfer each month, and your savings will grow automatically.
Keep your emergency fund separate: Keep your emergency fund in a separate savings account to avoid the temptation of dipping into it for non-emergency expenses.
Re-evaluate your emergency fund regularly: As your expenses and income change, you should re-evaluate your emergency fund to ensure that it is still sufficient.
By following these steps, you can build an emergency fund that will help you weather unexpected financial storms and achieve greater financial security.
Where To Invest Your Emergency Fund
Even with high inflation making cash an undesirable asset class, it is important to keep your emergency fund in cash or cash equivalents. We recommend keeping your emergency fund in a money market, savings account, or C.D. Each month we update the list of the most competitive Money Market, Savings Account, and CD rates available nationwide. If you have excess cash in a bank account, consider moving some into a more competitive cash equivalent.
Building an emergency fund is an essential step in achieving financial stability and security. By following the steps outlined in this post, you can create a plan that works for your budget and lifestyle. Remember that building an emergency fund takes time and dedication, but the peace of mind that comes with knowing you have a financial safety net is well worth the effort. Don’t wait until an emergency happens to start building your fund; start today and take control of your financial future.