One of the most important components of your personal finance portfolio is your emergency fund. Your emergency fund is as implied—to fund any emergencies that you might have.
It’s a hedge against the unexpected in life.
You’ve probably heard that you need to have an emergency fund, but like most people, you’re not sure how much you should put into it. Furthermore, you’re not even sure if you should save for emergencies while you’re trying to pay off debt?
Well, I’ll echo the sentiment of the other personal finance experts out there and state that you should have an emergency fund. And, even if you’re working to get out of debt, you should stash some cash too.
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There is no one right answer to how much you should save for emergencies, but I’ll share a few rules of thumb to get you started. Knowing these general guidelines will give you a target to aim for.
What is an Emergency Fund
Your emergency fund is the savings account that holds funds for true emergencies. It’s where you would draw money from in the case of an unexpected event that would require large sums of money that you wouldn’t have otherwise.
An emergency fund is your barrier against using credit to pay for things. It allows you to cash flow expenses without having to get into debt.
Lack of funds for emergencies is what typically hinders your ability from getting out of debt. When there is no emergency fund, the immediate reaction is to grab a credit card to pay for these expense.
If you want to become and remain debt free, it is critical that you put away money for a rainy day.
Having an emergency fund was critical for my husband and I when I was laid off. Fortunately, we didn’t have to dip in is since my unemployment didn’t last long; however, we had comfort in knowing that if we needed to, the money was there.
Unfortunately, that’s not the case for many Americans. More than 78% of households live paycheck to paycheck and don’t have any funds saved up to cover an emergency or unexpected lapse in employment.
It’s critical that you have something saved so that you are prepared for any downturn or unexpected event in your life.
Emergency Fund vs Savings
Although an emergency fund is a type of savings, they aren’t the same.
You save with the intent of one day spending those funds. An example is a sinking fund, where you are saving for a specific thing or event and event. The money will eventually be spent.
With an emergency fund, the hope is that you don’t have to spend the money. It’s really your last resort of funds to tap into in the case of an unexpected event.
What Qualifies as An Emergency?
Beyond having money saved for emergencies, you have to understand the difference between what the money should be used for and what it shouldn’t be used for.
True emergencies are those things that are unexpected and need to be addressed immediately. An example would be if your car tire blew and you needed to replace it in order to have transportation.
That’s something that will require you to spend a significant amount of money that you weren’t expecting at the time. Whereas, buying tickets to a Beyoncé concert before they sell out is not an emergency.
Emergencies are those unexpected things that are not included in your budget for that pay period, but need to be resolved.
Here are some examples of things that qualify as emergencies and things that don’t.
|Car tire blows & needs a replacement||Routine oil change|
|Unexpected layoff||Vacations from work|
|Medical emergency||Routine doctor’s visit|
|Car accident||Cosmetic car job (painting, stereo)|
True emergencies are things that can’t be planned for in advance. Your emergency fund allows you to have money available if those things occur.
Before dipping into your emergency fund, I recommend asking yourself these questions:
- Can this afford to wait? (Can this be budgeted and saved for at a later time?)
- Do I need this to survive? (Ex. Emergency surgery)
- Are there other options? (Can I rent a car for now?)
Know the difference between what is truly an emergency versus what is a want. What you want can wait, but emergencies can’t.
How much to Save for Emergencies
While you’re getting out of debt, saving for emergencies can be hard. That’s why the rule of thumb is to first save $1,000 for emergencies before you start putting extra cash toward your debt.
Having $1,000 put away in a high yield savings account is typically enough to cover small emergencies that may arise. You could easily afford a car repair or a medical bill with $1,000 in your bank account.
After paying off debt, however, you should aim to have more money stashed away. The rule of thumb at this point is to have 6-12 months of expenses in a savings account. This money will cover even bigger emergencies, like layoffs, long term disability, or major home are car repairs.
To calculate your expenses, you’ll need to first create a budget.
When you create your budget, you will have visibility to how much money you are spending for each expense category, such as food, shelter, transportation, etc. Calculate how much is required for you to survive at a minimum each month. You’ll need to save that amount to cover between 6 to 12 months.
Where to Put your Emergency Savings
An emergency fund should be held in a high yield savings account. High yield accounts allow you to collect interest on the money that’s in your account. So, essentially, you can make money from your savings just sitting there.
Put your emergency fund in a bank that’s separate from your general checking account to avoid the temptation of withdrawing from it unnecessarily. In the case of an emergency, you should be able to access these funds by transferring them into your main checking account—usually taking 1-3 business days or using a bank issued card.
One tip that Personal Finance Coach Valencia Morton recommends is also having cash on hand in case of an emergency. There may be instances where service providers—such as towing companies—will only take cash. You want to be prepared for these cases as well.
How to Build your Emergency Fund
Now that you know how much you should aim to save, you have to create a plan to actually save it. Here’s how you can build your emergency fund.
- Kick start your emergency fund by cutting expenses in your budget. It would surprise you how much “extra” money that you have tied up in dining out, unused subscription services, or that’s being spent on unnecessary items. Eliminate the unnecessary and put the extra money in your savings account.
- Start selling unused clothing and household items to make easy cash. You can sell online or have a yard sale. Put all of the profit that you make into your savings accounts and continue to add to it until you’ve reached your initial $1,000 or at least six months of expenses.
- Automate your savings from your paycheck. Have your employer automatically deposit a certain amount into your savings account every time you get paid. This means that you don’t have to think about it and the money is put away before you have a chance to miss it!
Remember, this account is for emergencies only. That means that you should set it and forget it. Take advantage of the high interest rates on the account and watch your money grow!
Having to deal with an emergency is never fun. Prepare for one to make things a lot easier.