Several moving parts come together to create a healthy, sustainable financial life. To be successful in this arena, though, you have to start with the basics and build from there. One foundational piece of the personal-finance puzzle is an emergency fund.
This savings is meant to act as the start of any financial plan you create. However, there are many misconceptions about emergency funds and confusion on how to build them. We’ve broken down the ins and outs of an emergency fund so you can understand the why and how behind this crucial financial planning tool.
Why Have Emergency Savings?
We all know that generally speaking, having some form of savings is a good idea. But it can be hard to fully understand the why behind an emergency savings “bucket.”
To start, it is helpful to recognize how emergency savings is defined. According to financial experts, your emergency savings is a liquid (easily accessible) account that acts as a cushion for your finances. Should a financial emergency arise, like an unexpected car or home repair, a surprise medical bill, or a significant tax liability, the emergency fund is used to cover this expense.
The reason for having an emergency fund is simple. Without an emergency fund, how are these unexpected bills covered? Well, for many, a credit card, payday or title loan, or personal loan is the answer.
While these financial vehicles are meant to provide consumers a way to pay for large expenses of time, they don’t come cheap. Credit card interest rates are often in the double digits. At the same time, payday and title loans may carry three-digit interest rates. Personal loans can be less expensive, but they can also be difficult to qualify for if credit has been an issue in the past.
So, enter your emergency fund as a smart and efficient way to handle life’s financial curveballs. Tapping into savings is a much more cost-effective strategy compared to borrowing money from a bank, credit union, or credit card issuer. In having the right amount set aside for the unexpected, you gain peace of mind knowing that, for most emergencies, you’ve got it covered.
One important item to note is that emergency savings should not be confused for targeted savings. With a targeted savings account, the aim is to set aside funds for a specific goal. If you’re planning to purchase a home, buy a car, take a vacation, or help out a family member, use targeted savings for these objectives. Keeping emergency savings separate from other savings goals helps organize your financial life in a clearer, easier-to-follow way.
How Much Should Your Emergency Savings Be?
Now that you know why an emergency fund is fundamental to your financial health, you may be asking how much should an emergency fund be? This answer is not so black and white, as many financial experts disagree on the perfect amount.
A general rule of thumb, however, is to add up your expenses (not your income) for a typical month, then multiply that by three. An emergency fund that equals three times your monthly expenses should, in essence, cover an unexpected bill. This amount is also beneficial should a job loss or furlough take place. The idea here is that you have just enough to cover three months of living expenses should your income stop altogether.
However, some suggest that having a larger emergency fund is a better, safer plan. Taking the same monthly expenses but multiplying that number by six or nine is going to result in a larger number, of course. But experts suggest that this emergency savings amount will go much further should substantial financial issues arise. Unfortunately, it can be a challenge to reach that amount of savings, and some argue that savers can miss out on other opportunities.
Interest rates on savings accounts are relatively low these days. Investing a portion of savings can help boost overall net worth over time, as investments may far outperform a typical saving account in terms of an annual return. However, a few of the top high-yield savings accounts do perform much better.
Also, if someone is trying to pay off debts, like student loans or credit cards, working toward a six or nine-month emergency fund can feel counterproductive. Why wouldn’t we just take those savings and apply it toward the debt balance to get that knocked out?
These considerations are not so cut and dried. They require taking a close look at your financial situation and determining which path – or combination of paths – makes the most financial sense both now and in the future. For most individuals, starting with the goal of three months of expenses in an emergency fund is the right first step. From there, evaluate the need to save more for the unknown, your ability or willingness to invest, and your debt obligations to determine your next move on the emergency savings front.
Easy Ways to Build Emergency Savings
Now that we know the why and (sort of) how much, we can focus our attention on how to get there. First and foremost, start with your budget. You need to determine if there are funds available to save each month. If there are, begin setting those aside systematically each pay period or each month. Set up an automatic transfer to your high-yield savings account and leave that on autopilot to reach your emergency fund goal.
If you are struggling with finding the dollars for savings, consider revisiting the budget. Are there items are you can cut out or bills you can negotiate down? This takes more effort, but it can make all the difference in having the recommendation emergency fund cushion or having to reach for debt in a financial emergency.
For those who find it hard to save, setting up automatic transfers is the best – and easiest – route to take, and can even earn you a higher annual percentage yield. A popular way to do this is through direct deposit.
Several digital tools can make this process even more effortless. Consider using apps such as Digit or Qapital to help you boost savings over time. These apps automatically save for you, based on rules you create or by analyzing your spending habits over time.
Final Thoughs on Building an Emergency Fund
Finally, don’t get discouraged. Saving three, six, or nine times your monthly expenses is no small feat. If you’re finding the budget is tight already each month, meeting this challenge can feel like an impossible task. Go easy on yourself and start with small steps. Set aside five dollars each week if that is what it takes, and try to build from that point over time.
Be cognizant of spending, so there are extra dollars to save each month. And give yourself time to reach an emergency fund goal, keeping in mind why it is essential to have that amount in the bank. These small but powerful strategies pave the way for the financial stability that comes from having an emergency fund.
