Emergency Fund: What It Is and Why You Need One
This article may contain references to some of our advertising partners. Should you click on these links, we may be compensated. For more about our advertising policies, read our full disclosure statement here.
Wouldn’t it feel amazing to have a safety net protecting you from your next financial hiccup? Imagine what it would mean to know your mortgage was covered, you could put food on the table, and your bills would be paid – even if you lost your job. You’d feel pretty secure, right?
That’s what an emergency fund can do for you!
What Is an Emergency Fund?
An emergency fund is money you set aside to use specifically for emergencies. Simply put, it’s a stash of cash that helps you cover unexpected expenses or an unexpected loss of income.
Along with starting a budget and tracking your spending, an emergency fund is one of the most important tools to have in your financial toolbox. It keeps your financial life from sliding off the rails at the first sign of distress. So whether your car breaks down or you have to miss work, an e-fund helps to smooth out the rough patches.
Why You Need an Emergency Fund
Here’s the thing: Financial emergencies happen to everybody. It’s not a matter of if but a matter of when. That’s why it is super important to have some money set aside and to prepare for the day it happens to us. With a fully stocked emergency fund, you’ll be prepared for almost any financial crisis that comes your way.
Think of an emergency fund like an insurance policy for your monthly budget. Although you use a budget to plan for known expenses, sometimes unexpected things happen. When an emergency expense pops up, simply dip into your emergency fund to take care of it. You’ll be able to pay for the expense, avoid debt, and stay on track with your budget. It’s a win-win-win!
Unfortunately, most of us are totally unprepared for the slightest blip on the radar. A 2022 survey from Bankrate found that only 44% of those polled had $1,000 saved for emergencies. Even more shocking, about 35% of respondents answered that they would need to charge it to a credit card, borrow from family and friends, or take out a personal loan. Yikes!
That is a massive problem just waiting to happen, and most won’t realize how big of a mess they’re in until it is too late. If this is you, don’t worry! We’ll show you how to build an emergency fund below.
When to Use Your Emergency Fund
So, when should you use your emergency fund? Here are some examples of when it might come in handy:
- Unplanned car repairs
- Unexpected home or appliance repairs
- Acute medical issues
- Loss of income
Keep in mind, you don’t want to use your emergency fund for just any old expense. Use it for emergencies only. For example, fixing a flat tire on your car is a great time to use the fund. Getting an oil change or paying for other routine maintenance would not be.
Before dipping into your emergency fund, it’s important to ask yourself a few questions:
- Is this expense unexpected?
- Is this expense required?
- Do I need to handle this immediately?
If you can answer “yes” to all of the above, then it’s probably a good time to use your emergency fund. If not, leave your emergency fund alone and plan for the expense in your budget instead.
How Much Should I Save?
In most cases, you should save at least three to six months of expenses in your emergency fund. This typically provides you with enough time (and money) to make adjustments after a sudden loss of income.
For example, if you lose your job, you won’t have to take the first offer available. When you know you have enough money to pay your bills for several months, you’ll be in a stronger position to negotiate and find a job that works for you.
Of course, having three to six months’ worth of expenses is only a guideline. The amount you should save depends upon your personal situation. If your income tends to fluctuate, your job isn’t particularly stable, or you’re hoping to start your own business, you may want to shoot for the higher end of the spectrum.
Personally, my wife and I keep about six to twelve months of expenses in our emergency fund. We are both self-employed, so we like having enough money saved to ride out any slow months. Our expenses are also super low and we’re debt-free, so it is fairly easy to keep that amount of money in our emergency fund while still investing for the long haul.
If you’re new to emergency funds, try not to get overwhelmed by the amount you “should” save. Saving something is always better than saving nothing. Sure, three to six months of expenses may seem like a ton of money right now, but with the right plan, you’ll get there in no time.
To make it easier on yourself, start by saving $1,000. That’s a great starter fund and – with a little work – it’s something you can achieve without too much stress. Use that success to build your fund even larger over time, and eventually you’ll get to the point where your emergency fund is fully funded.
Where to Keep Your Emergency Fund
When building your new emergency fund, it is important that you follow these two guidelines:
- Keep it somewhere separate.
- Keep it somewhere accessible.
One of the most important things you can do is to keep your emergency fund separate from your other spending accounts. This helps avoid any accidental (or intentional) mixing of money. You’ll know exactly how much you have saved for emergencies, and you won’t be tempted to use it to go to the movies or pay the electric bill.
Your emergency fund is special money that should be used for a special purpose. So why not give it special treatment, right? Keep your fund separate by opening a bank account specifically for that purpose.
The other thing to keep in mind is that your money should be accessible when you need it. Now, you don’t want it to be too accessible so you end up spending it on non-emergencies. (That’s why you keep it in a separate account.) However, you don’t want it tied up in financial products where it is unavailable, either.
For instance, using an investment vehicle such as an ETF or mutual fund for your emergency fund is generally not a good idea. Neither is a certificate of deposit. Yes, you might have the opportunity to earn higher (or lower) returns, but the money is usually difficult to access. You might also have to pay money in taxes or fees to cash it out.
Additionally, if you keep your emergency fund in an ETF or mutual fund, you might be reluctant to sell your investments – especially if they are down. This often results in using debt to cover the emergency instead. Bad move. This is exactly what we’re trying to avoid in the first place!
High-yield savings accounts and money market accounts (MMAs) are great places to store your emergency fund. These accounts typically offer a much higher interest rate than traditional savings accounts, and they fulfill the need to keep your money both separate and accessible. Here are a few of our favorite options and their current rates:
How to Build an Emergency Fund
Are you pumped to get started? I’m excited for you!
This simple strategy, called a “sinking fund,” will help you build an emergency fund quickly and effortlessly.
- Open a money market or high-yield savings account
- Decide the amount you want to save every month
- Create an automatic transfer (or direct deposit) in that amount every month
- Celebrate your first $1,000!
- Keep saving until you’ve reached three to six months’ worth of expenses
- Replenish the account as needed
Boom! It’s that simple!
Just set up a sinking fund, automate the process, and you’ll start saving hundreds of dollars without even thinking about it.
Tips for Getting Started
Open a high-yield savings or money market account. Remember, you want to keep your emergency fund both separate and accessible. Opening a new high-yield savings or money market account for your e-fund is a great way to accomplish both.
Use a sinking fund. Automate the savings process by using a sinking fund. Simply set up the automatic deposits or transfers, and you’ll be saving hundreds with almost no effort!
Set a goal of $1,000. When you don’t have any money saved, the thought of saving three to six months of expenses can feel overwhelming. Instead of focusing on the end goal, start by trying to save $1,000. This is a great “beginner” emergency fund because it seems much more achievable and will help you get back on your feet in a pinch.
Save $100 a month or 10% of your take-home pay. If you’re like most people, you can’t just plop $1,000 or more into an emergency fund. That’s OK. Building your fund is going to take time. Start saving smaller chunks of money instead. Try to save either $100 a month or 10% of your take-home pay, if you can afford it. Saving smaller amounts makes it hurt a lot less. Plus, it’s super motivating to watch that money pile up!
Only use your fund for emergencies. Again, an emergency fund is called an “emergency fund” for a reason. Don’t get tripped up and use it for non-emergencies. Ask yourself if the expense is unexpected, necessary, and immediate. If not, leave the money in savings until you really need it.
Use a zero-sum budget. If you haven’t done so already, start using a budget. Budgeting is the ultimate way to plan for your income and expenses every month. Our favorite budgeting method is called a zero-sum budget. Follow the link above to learn more!
Start now. There is no better time than the present to start building your emergency fund. Emergencies happen all the time, and you never know when you’ll need that extra money. Find a great money market account or high-yield savings account and start saving today!
Do you have an emergency fund? Has it ever come in handy when you needed it? Let us know in the comments below!
Great advice. The federal government will be mailing checks to millions of households who should have had an emergency fund to cover their expenses during this crisis. Before I get slammed for this comment, I am talking about those people who had the wherewithal to build an emergency fund but chose instead to spend the money on lifestyle.
I have over thirty years as a financial advisor. I met with many couples over the years and many of them had a higher income than I I. Yet they lived paycheck-to-paycheck. There were also many who said they could not afford to set money aside. Yet, they spent money on many things that I chose not to spend money on because I deemed my financial security to be a higher priority. For example, I have never had cable TV. An antenna to receive local stations works just fine. Probably saved me $20,000 over the years.
I do feel empathy for those struggling in low paying jobs do to no fault of their own and are now out of work.
I do not have much empathy for the people I described earlier.
I certainly don’t want to rub salt in the wound, but – yes – this pandemic and the economic fallout is exactly why an emergency fund is important. Unfortunately, a lot of folks are stuck in a really tough position right now, and I feel awful for them. All they can do right now is financially survive, but hopefully they will learn from this and start their emergency fund once they are back to work 🙂
Great post Greg, I was groomed to save for an emergency fund at a young age, so I’m grateful for that. Building an emergency fund will have unforeseen positive side effects, because it makes you ‘intentional’ and ‘accountable’. This accountability will inevitably cause you to save more and spend less. It’s a win/win!