An emergency fund is an essential part of making a solid financial plan. This is the money you’ll want to earmark for unexpected events, such as a surprise medical bill, costly car repair or temporary loss of your income.
With so many possible reasons why you’d need to tap an emergency fund, it’s critical to prepare and build a reliable one to avoid letting unexpected expenses lead you down the path to financial ruin.
“By nature, unplanned expenses are unexpected, so the sooner you’re prepared the better off you’ll be when the inevitable happens,” says Greg McBride, CFA, Bankrate chief financial analyst.
What is an emergency fund?
An emergency fund is cash savings set aside specifically for unplanned expenses, such as a big dental bill, home repair or loss of income. Using emergency savings to cover unexpected expenses is better than paying with high-interest credit cards or taking out a loan.
An emergency fund can give you peace of mind and prevent you from going into debt.
People normally build up an an emergency fund to help them during some of the following unexpected events:
- Unexpected medical expense
- Unforeseen living expense
- Emergency home repair
- Sudden auto repair
- Death in the family
How much to save in your emergency fund
Make small goals at first, such as saving $100, and then work your way up to a reserve to cover several months’ worth of expenses. While your savings goal will depend on your income and expenses, a general rule of thumb is to save enough to cover three to six months’ worth of expenses.
When setting your savings goal, you should focus on having enough to cover expenses, not on replacing your entire income, says Kevin Gallegos, vice president at Freedom Debt Relief.
“Remember, in an emergency, we don’t fund vacations, fancy new clothes, dining out or other luxuries,” Gallegos says.
Your emergency savings account should be able to cover six months’ worth of expenses, McBride says. For a lot of people, accumulating that amount of emergency savings is going to take some time.
“That’s a destination, not a starting point,” McBride says. “But the important thing is, if you’re saving consistently, you’re putting yourself on the pathway to get there eventually.”
A sole breadwinner, a business owner or a person with a highly variable income might want to aim for nine or 12 months’ worth of expenses in their emergency savings account, McBride says.
Why do I need an emergency fund?
Saving money for emergencies makes sense. Would you rather have to take out a loan and pay interest? Or use a credit card with a double-digit interest rate? Both options will cost you more than having cash on hand to cover the emergency.
We save up for other things, whether it’s to buy a house, a new car or pay for a wedding. Having a separate fund for emergencies is smart and gives you some peace of mind.
Many Americans aren’t prepared for an emergency
Only 39 percent of Americans could cover an unexpected expense of $1,000 from their savings, according to a Bankrate survey published in January.
In another recent Bankrate survey, 53 percent of people say that a $600 stimulus check will only sustain them for less than a month.
Not being able to pay for emergency expenses can lead to crushing debt and a pile of unpaid bills. That’s why the time to start saving for an emergency is today. If you save while things are good, you will be prepared when the unexpected happens. Having a high-yield savings account dedicated to an emergency can make a stressful situation easier to handle.
7 easy steps to get your emergency fund started
1. Make a budget and see where you can start saving more money
It’s important to know where your money is going so that you can find saving opportunities. Without budgeting, you won’t be able to maximize income and find ways to reduce or manage your spending. You can use Bankrate’s Home Budget Calculator to set your budget up.
If you don’t want to calculate your budget, the good news is that you can also automate this process by using a budgeting app. These apps will calculate your spending and earning for you, so that you can get a dashboard view of your financial situation.
Through careful budgeting, you may find that you need to cut expenses or perhaps increase your income. One way to boost the amount of money you’re taking in could be through a side hustle.
2. Automatically save
Using your budget, make your savings automatic by splitting a portion of your direct deposit into a savings account or money market account.
Make sure you’re maximizing the interest you’re earning by getting a competitive annual percentage yield (APY). Typically, online-only banks’ savings accounts and money market accounts offer higher yields than brick-and-mortar banks’ products.
If you’re just starting to save, look for an account with a low minimum balance requirement and no monthly fee. Again, online banks typically offer these features.
3. Gradually increase your savings
Increasing either the percentage you’re saving or the amount you’re saving from your checking account can give your savings a boost. You might not even notice a small increase in savings missing from your checking account.
4. Save unexpected income
At least a part of any windfall that you receive should be used to fund an emergency fund, unless you already have a sufficient one established. Unexpected money can come in the form of a cash gift, inheritance or winning a contest or the lottery.
A tax refund is another example of money that can help grow an emergency account.
5. Plan to cover at least three to six months of emergency expenses
You’ll determine this number from looking at your budget (from step one) and calculating how much you need each month to cover essential expenses. Rent or mortgage, food and transportation are some of these necessary spending categories.
6. Keep saving after reaching your goal
Emergencies may require more than a six-month cushion. In these situations, you’ll be relieved to have this extra money on hand.
Being unemployed for more than a year or being hospitalized for many months are both situations where you’ll be glad you have more in your emergency fund.
7. Put longer-term savings in a CD
Calculate whether any of your emergency savings won’t be used in the next year.
Consider seeking financial advice
Maybe you don’t have a handle on your finances and aren’t sure how much you could be saving for emergencies, retirement or other goals. Or maybe you do, but you’re still not confident you’re putting all of your income to the best use.
Hiring a good financial adviser might be one of the best things you could do for yourself. A solid financial plan can give you a clear picture of where you stand, how much you can spend and how much you could be saving for emergencies and other goals.
Even people who are frugal and pretty good with their money can learn something from the right financial adviser.
Where to keep your emergency fund
Your emergency fund should be easily accessible, but not so easily accessible that you’ll be tempted to make withdrawals for everyday spending.
Online banks are good locations for your emergency savings because you can’t just walk into the bank and withdraw your cash. Consider keeping emergency funds in a combination of locations, including an online savings account, money market account and short-term CDs.
To maximize your returns, you’ll want to consider keeping your emergency fund in a high-yielding account. The higher the APY, the more your savings account will earn. Online banks also typically offer higher yields than brick-and-mortar banks. Compare rates on Bankrate to find the right account for you.
But sometimes there’s more to choosing a bank than just the rate. In these instances, you can compare these features using Bankrate’s bank reviews to find the right bank for you.
Try and determine how quickly you may need these funds in an emergency and how you would be able to transfer, withdraw or use these funds.
Since you might be forced to use an emergency savings account as a transactional account in an emergency, a money market account can be a good option here – assuming the APY is competitive with the top savings accounts available. But there’s nothing wrong with having your emergency funds in a savings account either, since there should be a fairly easy way to get those funds moved into a transaction account, if needed.