Building an emergency fund can help you take on the unexpected bumps in life. And while it takes patience and consistency, it’s well worth the effort. Having one is a cornerstone of your financial toolkit.
When money is tight, the last thing you need is a financial setback. But unexpected expenses can crop up at any time, which is why it’s best to be prepared.
Having emergency savings can spare you a lot of headaches and stress when the unforeseen happens. Here’s how you can build an emergency savings fund from scratch.
What is an emergency fund?
An emergency fund is a cash reserve you set aside to meet sudden expenses when life throws you a curveball. Medical bills, home repairs or the unexpected loss of income from unemployment are some examples of costly emergencies.
Your emergency fund is like an insurance policy for strict emergencies. It isn’t money stashed to upgrade your car or to fund your next vacation.
It’s cash you’ve saved to cover an important shortfall, not to fund lifestyle expenses. It’s so important, in fact, that even some companies are helping their employees build one.
What are the benefits of building an emergency fund?
Having an emergency savings fund has benefits that go beyond the economic:
» Have peace of mind. Even if you’re not the sole wage earner, having an emergency fund will give you peace of mind. Studies show that money related stress can do a lot of damage to your health. Knowing you’re prepared to protect your family if a pink slip is handed to you is priceless.
» Manage uncertainty. Job stability is never guaranteed. If your employer goes through a rough patch, or the economy softens, it can be nerve racking. Having a stash of money to back you up can help you manage anxiety.
» Avoid more debt. An emergency fund helps you manage financial contingencies. If you don’t have one in place, and you have to face an unforeseen expense, you may have to resort to expensive credit card debt, hurting your finances.
» Adopt a great habit. Saving for an emergency fund can have the positive effect of making saving a habit. It’ll give a workout to your ‘saving muscles’ and could lead to making saving part of your lifestyle.
How much should you save in your emergency fund?
The size of your emergency fund will vary depending on your personal situation. Review your expenses and figure out how much of your money is going to pay for everyday needs and how much for wants.
Distinguish between needs and wants
Your regular expenses can be categorized as need and want type of expenses. Food, your rent or mortgage, insurance premiums and credit card payments are examples of needs. Cable, streaming services, digital subscriptions, and so on, are examples of wants.
You have more flexibility when you’re spending less than half of your income on need expenses. That’s because you have some slack built into your want expenses, which you can cut quickly should the need arise.
While it isn’t commonly stated, it’s fair to assume that the 3 to 6 rule assumes that you’ll tap the fund during a good economy. When the economy is slow, it’s better to have 9 months or more of expenses covered. The larger amount is justified since finding a job when the economy isn’t doing well can take longer than usual.
Don’t feel discouraged by the amounts above. There’s no set amount for an emergency fund because everyone’s situation is different. Adjust the guidelines if you need to, but the important thing is that you get started. It’ll give a workout to your saving muscles and help you save money more consistently.
How do you build an emergency fund?
It might seem difficult to save money when you’re already juggling multiple expenses. One way to ease into it is by using small, incremental steps. Set a doable goal at first that stretches you a little.
Set a goal
If saving 3 to 6 months of expenses seems difficult at first, start with $1,000. Once you reach it, set another, higher goal until you have a few months’ worth of expenses covered.
Think of it this way: your emergency fund is like a safety net; if it’s thin, when you have the occasional fall, you’ll get hurt.
The best time to start saving for your emergency fund is today. You want to put yourself in the right path to get to your goal. And you can’t get there if you don’t start.
If you’re struggling to find the money you need to get started, go over your budget. Or look for ways to make some extra money. You can do it even from home. Read our 23 Smart Ways to Make Money from Home.
Add it to your budget
Cut back on your ‘want’ type of expenses to find the money you need to start funding your emergency savings. Treat this amount as if it were a fixed expense, but one that you pay to yourself.
This savings-as-an-expense approach can be very useful. It’s a self-suggestion tactic that tells your mind that this is an amount you ‘have to’ set aside, and not one that you ‘should’ set aside. In other words, you make it a need expense that you must cover.
Make it recurring
Set up a recurring transfer from your checking to your savings account. With a recurring transfer, you’ll grow your savings consistently and make it easier to figure out the time when you’ll reach your savings goal.
Doing the math can be pleasantly surprising. If you set aside $25 every week, for example, you’ll get to $1,000 in 10 months.
Trap excess cash
When you get a salary increase, a bonus or an unexpected windfall, you might be tempted to spend more. If this happens to you, fight the urge to spend and put the excess money in your savings account immediately.
If you get a raise, increase the amount of your recurring transfer. By moving the cash, you’ll be less tempted to spend it and you’ll be in a better position to reach your savings goal sooner.
Being relentless is about sharpening your mental focus and being able to block distractions. Focus on something that you care deeply about to help you stay on the path to reach your savings goal.
Having an emergency fund is not only good for you, it’s also good for your loved ones. Visualize reaching this important savings goal. And focus on the peace of mind you’ll experience when you achieve it.
Where do you keep your emergency fund?
The money in your emergency fund needs to be kept in a safe account that’s easily accessible to you. When the need arises, you want your funds to be readily available at a moment’s notice.
Keep it safe
Your IRA is not the best place to keep your emergency fund. Higher investment returns are only available by taking on investment risk. And risk is something you don’t want to mix with your emergency fund. Besides, you’re likely familiar with the small print that comes with these types of accounts: “Not FDIC insured, no bank guarantee, may lose value.”
Use separate accounts
It might seem more practical to keep your emergency fund in your regular savings account. But that’ll make it too easy to take a “loan” from your fund and dip into it.
Keep your emergency fund in a new, separate account. It’ll be less tempting to spend the money if you don’t see it every time you access your regular transactional accounts.
Earn a competitive return
Having an emergency fund is a prudent idea. It’s even better if your money is earning higher competitive yields. You may struggle with the idea of keeping thousands of dollars sitting in a low-yielding savings account. But there’s other alternatives.
Online banks’ high yield savings accounts offer better rates than traditional banks, since they don’t run the same overhead costs that regular banks do. Also, you can make unlimited deposits and access your money with the same frequency as a typical savings account.
» Related: You can compare higher yielding savings accounts using this simple tool.
Saving for and building an emergency fund is part of a sound financial plan. Start it by setting a reasonable goal you feel you can manage. You’re always able to increase your target amount as saving gets easier for you.
The money in your emergency fund needs to be readily available, since financial difficulties can strike at any time. And you want to keep it safe. An FDIC-insured high yield savings account is a safe alternative.
Starting today can help you get through financial difficulties later on. Your family and future self will be glad you did.