Personal finance has been in the spotlight for the past few weeks. Markets have taken a downturn, and many millions of Americans have either lost their jobs or are in danger of losing them. We are now in a situation where many people are facing dire circumstances in terms of their finances. Many families are struggling to pay rent and utilities. It’s times like these that can be made a little bit easier with the help of an established emergency fund.
According to a survey by GoBankingRates, 69% of respondents had either $0 or less than $1,000 in savings. The top reason respondents gave for not saving more was because they were living paycheck to paycheck.
Given the recent reminder of the kinds of curveballs life can throw, there’s no better time than now to begin to put a savings plan in place. If you have an emergency fund, you’re probably thanking the brilliant person who encouraged you to start one in the first place. (Big shout out to Dave Ramsey.) If you don’t have an emergency fund, maybe this is the kick you need to start building yours. Remember that it’s never too late to start. Let’s begin with the basics.
What is an emergency fund?
An emergency fund, which is also known as a rainy day or reserve fund, is an amount of money kept independent of regular savings meant to be available in case of an emergency. This extra cushion keeps your financial posture secure without the worry associated with not being able to afford an unanticipated expense.
Why do I need one?
You need an emergency fund to protect you from life interfering with your bigger financial plans. Without the buffer of an emergency fund, life will continue to knock you back as you try to pursue debt reduction or freedom from living in a paycheck to paycheck cycle.
I had to have an emergency to appreciate the benefits of an emergency fund provided. When a flat tire presented as my first unexpected expense, I didn’t stress out about it. I had the tire repaired, paid from my emergency fund, and moved on with my life. It almost seemed too easy, and like it should have been more stressful than it was. It only took one use, and I became hooked on the feeling of stability associated with an emergency fund.
How big does my emergency fund need to be?
The amount of money to keep in an emergency fund is a personal decision. Base the amount on your monthly expenses, aversion to risk, and job stability. To come up with an amount, try answering the below questions.
- What are your monthly living expenses? (Be sure to include all of your recurring debt payments, bills, utilities, transportation, housing, and food costs)
- How long would it take you to replace income if you lost employment?
- What amount of money would it take to give you warm fuzzies when you think about being prepared for an emergency?
If you think about the purpose of this fund, it will help you determine what is right for you. The purpose of the fund is to absorb risk, so the more risky your situation, the greater the emergency fund you should have.Dave Ramsey
In our family, household expenses are around $3000/month, and income replacement would take 2-3 months. For these reasons, we decided on a $30,000 emergency fund as the goal amount, primarily due to my risk-averse nature. For me, having ten months of living expenses in the bank is the amount that lets me sleep well at night. This is enough of a buffer for me to know we can afford to handle whatever comes our way. Your number might be a lot lower or even a bit higher than mine, and that’s okay. Your number should be what you know in your heart is going to give you peace of mind.
The most important thing to remember about an emergency fund is that you have to start somewhere. $50 in your emergency fund is better than $0!
Where should I keep it?
There are a few options for where to keep your cash, depending on how much you trust yourself. Below are a few places to stash your fund:
- Your existing savings account – Do you have the ability to withhold spending the earmarked money on non-emergencies if it’s somewhere you can see? This option takes a lot of willpower. You will have to mentally segment your emergency fund savings from any other savings you have. This is difficult to do and was never an approach I took.
- A new savings account with your primary institution – When I started my emergency fund, I chose this option as I knew that if I saw the money in with my regular savings or checking, it would be too appealing to use it right then.
- A separate savings account with a new institution – After I had built up several thousand dollars in my emergency fund, it started to look quite tempting to use for a big purchase. I decided to move the fund to a different, online-only bank for safekeeping. Having the money in a separate login with a separate debit card makes it so much easier to keep it out of sight and out of mind until it’s needed.
How do I build up my emergency fund?
Now that you know where you’ll be keeping your emergency fund, there are a few ways to siphon off your money to where it needs to be:
- Manually move the money at set intervals – Consistency is key. I recommend moving money right after you get paid to ensure you won’t use it for something else.
- Set up a separate direct deposit straight to your emergency fund – I found success in setting up two direct deposits from my previous employer. I signed up to have $250 from each check routed directly into my emergency fund. The remainder went into my regular checking account. Since the money never hit the light of day in my checking account, I didn’t feel the temptation to use it. I also liked knowing that my emergency stash was always building in the background without me having to touch it.
- Transfer anything left in your checking account on payday – When I was first starting my emergency fund, I would take the balance in my checking account on payday and transfer that once my deposit hit. Starting fresh with a new paycheck made it easier to budget and also allowed me to move small amounts into my emergency fund. Otherwise, those small amounts get absorbed into the available funds in checking. Sometimes it was $42, and sometimes it was $242, but every little bit helped to build the fund quicker.
No matter which method you choose to get money into your emergency fund, the most important thing is to stay consistent. From the start, it’s critical to know that this could be a multi-year process. I started my emergency fund in 2016, and I’m only now seeing the light at the end of the tunnel. Most importantly, refrain from using the money for anything that doesn’t qualify as an emergency.
When can I use it?
Now that you have your emergency cash nestled away nicely in a savings account, the question becomes, how do I know what qualifies as an emergency? My husband used to say he had an “Emergency Vacation Fund,” which I explained repeatedly is not a real thing. What constitutes an emergency is going to be subjective and a personal decision. There are several commonly agreed-upon situations that qualify as emergencies.
- Job Loss – Replacing income while you’re out of work is a fantastic use of the fund.
- Car Repair – This means keeping your existing car running or replacing it with a used vehicle if yours has completely bit the dust. This does not mean buying that new car you’ve had your eye on or getting the new truck bumper you want.
- Medical Expenses – Unexpected medical expenses are a great use of emergency funds.
- Home Repairs – If the furnace goes up in the middle of winter or the AC breaks in the heat of summer, you’ve got an emergency on your hands.
What are the benefits of having an emergency fund?
- Less Stress – A whole new world opens up where you are no longer sweating the small stuff. Financial stress levels significantly decrease once you realize that you’ll be okay in the event of job loss or a car breakdown. It’s a kind of internal calm that you have to feel to believe.
- Ability to take some financial risks – Once you’ve funded your emergency fund and you are no longer putting money towards it each paycheck, cash flow will increase, which equates to more freedom. Maybe you’d like to back your friend’s new small business idea, invest in that “risky” stock you’ve been eyeing for the last year, or try out a new kind of investment altogether, like art or farmland.
- You can leave your job – I recently left an employment situation for personal reasons. I felt comfortable doing so, knowing that I have very low expenses and over half of my completed emergency fund in the bank. Without my emergency fund, I would never have been able to sustain several months of a lower income to pursue my dreams. (Follow this series to track my progress as I wade through the trials of the Gig Economy.)
A world of possibility opens up after transitioning out of living in a paycheck to paycheck existence. You owe it to your future self to start planning now. Building an emergency fund will enable you to live your best, less stressed life.
Disclaimer: The above is my own opinion and is for informational purposes only. Views expressed above are not intended to be investment advice. While I might have some great ideas, seek a duly licensed professional for investment advice.