There is wisdom in the adage that says to hope for the best but plan for the worst. While having an optimistic outlook on life is great, it is wise to have a safety net in case things don’t go according to plan. This means having an emergency fund with adequate money in the bank.
What is an Emergency Fund Used For?
Emergency Fund Definition
Savings are not always sufficient to cover immediate expenses, creating a need for a cash buffer. An Emergency Fund is cash set away that provides financial security and peace of mind for unexpected costs in the future. An emergency fund will help in the following situations:
- Medical Emergencies
- Unforeseen Unemployment
- Unexpected Home Repair
- Car Trouble
- Unplanned Travel Expenses
Medical, dental and veterinary emergencies are an unavoidable aspect of life and most cannot be anticipated. Car accidents, sports mishaps, slips and falls, heart attack and other major health events, broken bones, sudden pet illness, and chipped or broken teeth are just a few examples.
The financial impact of such an emergency can be catastrophic unless you’ve established an emergency fund to help cover the costs of a necessary medical expense. This is one of the most important uses of an emergency fund.
Abrupt unemployment is not uncommon, and it can happen to anyone, no matter where you work. Whether your place of work experiences a fire, natural disaster, or supplier going out of businesses; or you have to provide short-term or long-term care for a loved one, there are variables outside your control that can affect your employment status.
When it comes to saving money, you need to ask yourself how prepared you are for sudden unemployment. Surveys taken of the average American revealed that in the event of losing one’s job, the majority of people wouldn’t have enough savings to cover their monthly expenses for more than three months. In order to be better prepared during times of economic uncertainty, you should start by increasing your emergency fund.
Unexpected Home Repair
When a natural disaster occurs, your house or apartment may need major repairs. For example, if your home’s roof is damaged by high winds, rain or a fire, you may need to replace it. When pipes burst in cold weather, you may need to repair them or have them replaced. If you live in a flood zone or near a body of water that can cause flooding, you may need to fix water damage and repair electrical wiring. If a heater or air conditioner breaks down in an older home, you may need to replace these appliances.
Even though it rarely happens, a major disaster could leave your home unlivable. You’d likely need a place to stay and live while you rebuilt. Do you have money available to cushion or absorb such costs?
Even if you keep your car well-maintained by performing regular auto maintenance and services, you may still run into car trouble. Well maintained cars can still breakdown and accidents can happen. Instead of falling back on credit cards, an emergency fund is a better option when unexpected car repairs are necessary. It will save you the extra interest fees typically charged by high-interest credit cards.
Unplanned Travel Expenses
If a member of your family becomes ill and requires you to assist, will you be able to afford to take time off work? You may need to travel a large distance, which could mean paying for airfare and a hotel.
If you need to evacuate your home to escape harm for some reason, you will also incur travel costs.
You also should remember that we are not talking about any travel expenses; a summer vacation, for example, should not come out of your emergency fund amount. Build a separate “vacation fund” so that you can enjoy recreational trips without depleting your savings.
How Much Should Your Emergency Fund Be?
What is an appropriate amount of cash to have in an emergency fund? Is a $5k emergency fund enough? What about $10k? An emergency fund should be equal to approximately 9 months of projected living expenses. If you’re self-employed or live in an area with high unemployment rate, save 12 months of expenses instead of 9 months. This may seem like a lot, but it will ensure that you are prepared for any potential financial setback.
In order to have this amount saved, you may have to temporarily reduce your spending level. However, you will rest easy at night knowing you are prepared for life’s unexpected events.
To calculate your projected living expenses, add up the following for an average month:
- Housing costs including rent, HOA dues, utilities, and internet
- Groceries, along with pet food
- Medicine prescriptions, out-of-pocked healthcare, and health insurance premiums
- Required transportation costs for work or school, including gas and insurance
- Mortgage, credit card, and any other debt payments
- Any other regular, and necessary, expenses
Do not include expenses that could be scaled back in the event of a prolonged financial burden. These expenses may also be called discretionary or non-essential expenses. For example:
- Entertainment costs
- Eating at restaurants
- Gym membership
- Investment contributions
Once you have arrived at a number for your projected monthly living expenses, multiply that number by nine to calculate your emergency fund. This dollar amount will give you a sense of what you would need in the event of a job loss or other financial predicament.
How to Start an Emergency Fund
If, for example, your monthly expenses are $2,500, you will need an emergency fund of $22,500 cash in a savings account. This can seem like an insurmountable task, but it isn’t. Begin saving money for an emergency fund by breaking the process into small steps and making it part of your routine. To get the process rolling, we’ll suggest practical tips that are both manageable and effective.
Where to Put an Emergency Fund
First, we recommend putting the emergency fund money in a bank account that you won’t see often. If you use mobile or online banking, ask your bank to hide your emergency fund account from your login screen. Better yet, open a separate savings account at a different bank. Separating this account from your normal bank account will keep you from spending too much on impulse shopping.
One of the best ways to get started with your emergency fund is through a new money market savings account. These accounts offer a higher interest rate than traditional checking or savings accounts, and most require a high minimum balance to open an account and/or avoid fees. It should be easy to access, but not too easy. This can help you only withdraw funds in cases of emergency. If you don’t have the required minimum balance, open a standard savings account instead.
Should You Invest an Emergency Fund?
Many people ask, “Should I invest my emergency fund?” The answer is no, you should not. The funds should be kept in cash so you can easily access it. If the economy is in a downturn, you do not want money meant for emergencies invested in stocks or other investments that could become worthless.
Starting to Save
To start an emergency fund, begin by saving small amounts of money on a daily basis. If you carry cash, deposit a small amount at the end of every day at your bank’s ATM. If you do not carry cash, take a portion of your paycheck and have it deposited directly into the emergency fund. Setup the direct deposit to automatically happen after payday, so you can don’t have to think about it. After a few weeks, you should be well on your way to having 9 months of living expenses saved up.
Build up your emergency fund every time your financial situation improves. If you get a raise at work, put some of that money into your savings account.
Once you’ve created the emergency fund, leave it alone. Don’t take out any money for anything that’s not an actual emergency.
Reduce Your Spending
Simply saving money will not be enough. You may have to cut back on spending as well.
Find ways to do for yourself what you currently pay others to do for you. If you have a gardener or cleaning service, cut that expense and do the work yourself. If you dine out often, reduce it to once a week and cook for yourself. If you’re a member of a gym, stop going and start working out at home instead. If you have an accountant, consider using tax preparation software instead and paying for an accountant only when you need one for complex business tax issues.
Another idea is to get rid of cable TV or streaming subscription and watch only what’s available for free on YouTube, Twitch, or broadcast networks. If you have an automobile payment, trade in your car for a cheaper one – or sell it altogether and use public transportation. Another option is to take on a side job – some type of part-time work that brings in extra money on top of your regular job. The key is to find extra ways to make money without spending too much time on them or using up all your free time.
Start selling stuff. Do you really use all that stuff? There are things lying around your house that you don’t use anymore but could sell. Sell old furniture and electronics on Craigslist or eBay. Or consider holding a garage sale this weekend.
It sounds like a lot of work and a ton of effort that will make your life less fun. And to some extent, that’s true – if you’re not currently doing these things, it’ll be an adjustment. But if you commit to doing the work, you’ll see major benefits in your emergency fund.
Make Saving Money a Routine Practice
Getting into the habit of saving money is a great way to achieve your financial goals. By making saving money part of your daily routine, you can set yourself up for success and build a balance to tap into in case of emergencies.
Even if it’s just a small amount each week, regular saving will add up over time. Start small, even with as little as $10 a month. Once you’ve mastered that, you can increase your monthly contributions and work towards greater goals.
If you cannot save $100 per month, you should save whatever amount of money you can. Never talk yourself out of saving money because you can save only a small amount: even in a lean month, saving is better than not saving at all. Once you have an emergency fund equal to 9 months of expenses, resume your normal spending habits or save more money for a new goal.
Emergency Fund Summarized
An emergency fund can help you avoid a financial collapse if you are faced with an unexpected hardship. They create peace of mind during troubling times and reduce financial anxiety by providing a safety net. You won’t be tempted to spend money on a whim if you make this bank account separate from your other, more accessible accounts.
In case of emergency, making sure your finances are intact can save you from going into bankruptcy. An emergency fund will help you avoid using credit cards or withdrawing from retirement accounts when an unexpected expense arises, mitigating the pressure to overspend and pay hefty penalties.