Are you tired of not having enough money when unexpected expenses arise? Are you sick of never being able to pay down your credit card and always having a growing balance? What about when a real emergency comes up? What do you do when your child falls and breaks his arm, or when your aging parents need your help and you must buy a last-minute flight across the country?
What you need is an emergency fund.
You might have heard before that you should have an emergency fund. That is true for practically everyone.
Emergency funds are vital to your financial success because of the risk and impact of emergencies. Emergencies come in all shapes and sizes, but the critical part to understand is that they do occur. Everyone has unexpected expenses.
Examples of relatively common emergencies and unexpected expenses include vehicle problems, appliance breakdowns, job loss, medical catastrophes, natural disasters, or other family emergencies. Emergencies like these are virtually inevitable, but the consequences can be mitigated with proper preparation. You will be happy to be prepared when your emergency does hit.
When you think about it. Emergency funds are really a form of self-insurance against unexpected and costly financial situations.
Why Is an Emergency Fund Important?
Why do financial professionals recommend that emergency funds are so important to your financial plan? Couldn’t you just use credit if you get in a bind? The goal is to get out of the cycle of living paycheck to paycheck. To do this, you need to avoid the negative repercussions of an emergency on your financial health.
Relying on credit in an emergency might only make that cycle worse. Most people’s first choice of emergency money is credit cards. There isn’t a problem with using your credit cards as the first line of defense if you do have the money set aside somewhere to pay the corresponding credit card bill when the statement comes due.
If you have to turn to credit – especially short-term, high-interest credit like payday loans or title loans – it only compounds the problem. An initial emergency of $1,000 could end up costing you $1,500 or $2,000 because of the fees, interest, or penalties that come with not having the cash on hand.
Then, if you factor in the impact that it can have on your credit, it could cost you tens of thousands in the long run. In that regard, you can’t afford to not have an emergency fund.
Not only does this all create financial issues, but it can be stressful for you and your family. An emergency expense can ripple into your other spending, making you late on other bills, miss out on different experiences and opportunities, and in some cases, force you to go without something altogether.
Having an emergency fund is not only about preventing problems. There are also positive consequences of keeping a reserve. Of course, you will be able to capitalize on other opportunities when they arise, like a new job across country or investment opportunity. But also, recent research concluded that having a reserve of money can improve your decision-making ability.
It’s also important to note that your emergency fund is fundamentally different than having a dedicated account or fund for future, earmarked expenses. That’s where a sinking fund would come into the picture. Common examples would be contributing towards an annual vacation, purchasing new skiing equipment, or even a new car.
As you may be able to extrapolate from above, it is incredibly important to have an emergency fund. But it is even more important to have a well-stocked emergency fund if any of the following apply to you:
- Your credit score isn’t great
- You generally live paycheck to paycheck
- You have a variable or inconsistent income
- You have family or dependents that rely on you
How Do You Build an Emergency Fund?
You may be asking now, “Where do I start?” or “Can I really save that much money?” The answer is yes. You can save enough money. Consistency and diligence are crucial to your success.
If you have a strong enough reason or motivation to create an emergency fund, then you will come up with a way to save the money. You need to create a plan. Here are a few practical tips to get started as you decide where to start and how to approach it:
Take a look at your monthly cash flow – or budget – and determine how much you can reasonably save. You may have to cut back on some expenses temporarily. Don’t fool yourself by thinking that there is nothing left to cut back on. After trimming your expenses, you could consider cutting back on your 401(k) savings for a short time, particularly any portion above the required contribution to qualify for a full employer match, while you build up your emergency fund. Once you have determined how much you can save, the next step is to pay yourself first by automating your savings.
Automate your savings! Automation is one of the most powerful tools you can utilize. We, as humans, are sometimes lazy. It is just a natural human tendency. When it comes to saving, it takes a lot of work to save money month in and month out. Automating this process is wonderful because it uses our own laziness to our advantage. Ideally, you will automate your savings at the first of the month, or immediately following each paycheck, because then you always “pay yourself first”.
Having a separate account is essential for your emergency fund. It is too easy to spend the money in your savings account, especially when it is viewed in tandem with the balance in your checking account. Having a separate account often puts just enough distance between you and your money to avoid making impulse buys that you later regret. And to top it off, a different account can allow you to find a higher yield than you might have in your primary bank account.
The Right Amount
“How much should you be saving?” you might ask. Savology recommends that you start with the goal of $1,000 in an emergency fund. Once you reach this goal, pat yourself on the back. You now have more in an emergency fund than 60 percent of Americans.
Once you have $1,000, your next goals should be to save one month of expenses, then three months of expenses, and ultimately six months of expenses. Once you have six months of expenses in your emergency fund, then you have completed your goal. Well done!
You don’t have to calculate this on your own. The Savology platform can help you identify where you are in your financial journey and how much of an emergency fund you should be working to build.
What should you do if you don’t have a predictable income? Well, if this is the case, you should be much more disciplined with knowing your monthly expenses and sticking to them. During months where you make more, it is important that you set aside that money. Then on months that you don’t make as much, you can easily pull from your emergency savings. Depending on how much your income varies, it might be smart to have more than six months of expenses set aside to account for the lean months.
Where Do You Keep Your Emergency Fund?
There are three things that you should consider when deciding where to put your emergency fund. They are access, safety, and rate of return.
Access is necessary because when a real emergency hits in your life, the rate of return is less important than the ability and speed to get your hands on your money. While you don’t want it to be as accessible as your standard checking account, when you really need the money, you should be able to access it without much difficulty. For ultimate ease of access, you may even want to have at least $500 in cash at your home stashed away in a safe place.
The rest of your emergency fund should be located at a bank or credit union in a high-yield account. If you have credit cards with a reasonable credit limit, then having your emergency fund at an online savings bank would be ideal because it will give you a higher interest rate on your money, and you can get the cash within two business days. If you don’t have any credit, or a reasonable credit limit, then you may need to have the money in a local brick and mortar bank where you can go personally to get the money if required. You will also be able to transfer money to your checking instantly and pay for things as needed.
Having your emergency fund in a safe place is also essential. With the money you keep at home, you should consider locking your money up somehow instead of just hiding it in your sock drawer or under your mattress.
The money you keep at the bank should be FDIC or NCUA insured. This means that you have the insurance of the United States Government backing your savings up to $250,000 per bank per person. Most brick and mortar banks and online savings banks are FDIC insured, but not all cash management accounts are.
You also want to protect against the risk of loss. This means that you shouldn’t invest your emergency fund, at least the initial three months of expenses.
Once your emergency fund gets over that amount, then you can afford to take on a little more risk with that money to increase the rate of return. It is important that you are more conservative with your money that is set aside for emergencies so that you don’t lose it during a market downturn, which is likely when you will need it the most.
Rate of Return
The rate of return is probably the least important of the three things you should consider when deciding where to put your emergency fund until it is significantly large.
As mentioned previously, if your emergency fund is less than three months of expenses, then the most amount of risk you should be willing to subject it to is an online savings account. Here you will get about the Fed Funds Rate of return on your money. For the portion of your emergency fund that is over that amount, here are some options to consider where you can keep it:
- High-Yield Savings Account
- Laddered Certificate of Deposit (CD)
- Treasury Bills (T-Bills)
- Cash Value Life Insurance Contract
- Precious Metals (for a small portion)
- Brokerage Account
Start by getting at least $500 but no more than $1,000 in cash at home.
Next, move to a high-yield savings account where you will keep at least three months of income. If you want to keep things simple at this point, just keep all six months of emergency funds in your high-yield online savings account.
If you are looking to get a little better rate of return on your money, you can consider the options mentioned above for your money that accounts for three to six months or beyond.
What are the next steps?
As you build your emergency savings, remember that if you have a strong enough reason why, then you will be able to achieve your emergency fund goal. Carefully consider where you will put your emergency savings and remember to balance your ease of access, the safety of the funds, and the rate of return you will get on your money. Once you have determined where to keep it, take a look at your cash flow and determine how much you can save. Be sure to set up automatic transfers for this amount. Start small with the goal to save $1,000, and before you know it, you will have a healthy emergency fund.
Having a healthy emergency fund is one of the best indicators of financial stability and success. If you put in the time and effort to build your emergency savings, you will be grateful when an emergency hits.
As you can see, there is a lot more to consider than you may have thought when it comes to your emergency fund. If you would like help deciding what online savings account is best for you, visit Savology.com to create your financial plan. The Savology platform can provide custom recommendations for you and provide access to our favorite industry partners.