Unexpected expenses are a part of life. Unfortunately, according to the Federal Reserve, 39% of Americans would struggle to cover an unexpected expense of $400.
If you want to increase the chances that you’d be able to cover an unexpected expense — without the need to turn to debt — an emergency fund can help.
But what is an emergency fund, and how do you get started? Let’s take a look at how you can shore up your finances with help from emergency savings.
What is an emergency fund?
An emergency fund is a pool of money you can dip into when unexpected expenses pop up.
“Your emergency fund can provide you with ready cash when you run into a bit of financial trouble,” says Tom Drake, a financial analyst and founder of the financial education website MapleMoney. “The idea is that it sits there, liquid, waiting to protect you when you need a car repair or an appliance breaks down.”
Having an emergency fund can help keep you out of debt, Drake points out. When you can dip into your emergency savings to pay for a $600 car repair, you don’t have to use a credit card.
“Many people who turn to credit cards in an emergency just don’t have the funds to pay them off quickly, so they end up paying interest,” says Drake. “When you have an emergency, you can avoid paying interest to someone else if you have the money available.”
When should I use the emergency fund?
Once you build an emergency fund, it’s important not to deplete it for non-emergencies.
“Be honest about why you’re taking the money out,” says Jim Wang, money expert, entrepreneur, and founder of the financial website Wallet Hacks. “You know you need to buy a new refrigerator if the old one breaks, but do you really need a new TV?”
Wang also points out that it makes sense to use your emergency savings when you experience an unexpected financial shock, like an illness or job loss.
“You might need the money to meet your health-care deductible after being in the hospital,” Wang says. “Or maybe you’ve lost your job. Apply for unemployment benefits, and then tap into your emergency fund to help you cover necessities.”
How big should my emergency fund be?
There’s no one “right” answer to how much is best when you build an emergency fund. Financial guru Dave Ramsey recommends a “starter” emergency fund of $1,000. He suggests saving up this amount before paying off any debt you have as a way to handle many of the smaller unexpected costs that can crop up.
However, your personal financial needs will likely dictate how much you should save. In general, Drake suggests, base your emergency fund on your monthly expenses.
“Start by adding up how much money you need each month to cover the necessities,” Drake says. “Figure out what it costs to live — housing, groceries, bills, and utilities. Once you have that number, you can create a savings goal.”
Wang points out that experts vary widely when it comes to how many months’ worth of expenses you should save up.
“Some experts suggest that [saving] three months’ worth is fine, although they might say six months’ worth is better,” Wang says. “However, if you’re concerned about a recession or really want to be able to handle a long-term issue, it can make sense to work up to nine or 12 months’ worth.”
The key, according to both Drake and Wang, is start with whatever you can and then gradually build an emergency fund that works for you.
“You want to feel relatively comfortable, knowing you’re probably going to be okay for a few months if something catastrophic happens,” says Drake. “But in the meantime, just having a few hundred dollars can provide peace of mind since you won’t have to turn to credit cards each time the car breaks down.”
Where should I keep my emergency fund?
There are a few characteristics that identify a good place to keep an emergency fund. Wang and Drake both say an emergency fund should be:
- Liquid (in cash or easily convertible to cash)
- Low risk (or insured by the Federal Deposit Insurance Corporation, or FDIC)
- Easy to access
- Low fee (or fee-free)
While it might be frustrating that the money in your account isn’t offering a big return, Wang says, the idea isn’t to see a huge gain. That money is designed to provide quick capital as needed.
“Understand the purpose of the money,” says Wang. “When you meet some of the basic goals for your emergency fund, you can consider opening a taxable investment account and putting the excess there for better returns. But you always want enough liquidity somewhere to immediately get the funds you need in a pinch.”
Some common types of accounts for an emergency fund include:
- Savings account: In general, says Drake, it’s a good idea to look for a high-interest savings account. It’s possible to get yields of above 2.00% in many cases. Even Wealthfront offers an FDIC-insured account with a yield above 2.50%.
- Checking account: It’s also possible to keep your emergency fund in a checking account, which allows you easy access with the help of a debit card. However, that accessibility comes with a cost. Wang points out that many interest-bearing checking accounts have much lower yields than savings accounts, and some come with higher minimums or requirements to have a connected savings account.
- Money market account: Usually, a money market account has a competitive rate and can sometimes come with debit card access, according to Wang. However, minimums to get the best rate can be high.
Carefully consider what type of account might work best for you, and keep your money where it is likely to do you the most good.
How to build an emergency fund
Building an emergency fund can feel like a daunting task, but it might feel easier if you break your goal down into chunks.
“Don’t feel like you have to have everything all at once,” says Drake. “The important thing is to just get started. Start today so you have a chance at a more secure tomorrow.”
Here are some tips on how to build an emergency fund over time.
- Set aside a portion of your income every month. Figure out how much you can afford to put into savings each month, and be consistent.
- Break it down to a smaller amount. If you need to streamline it further, you can set aside a specific amount each week. For some people, the idea of saving $5 a day or $25 a week is easier to fathom than putting aside a bigger amount once a month.
- Make it automatic. Rather than having to remember to set aside the money, automate it. Check with your employer to see if they allow you to use direct deposit to put a portion of your paycheck in another account. If that’s not an option, set up an automatic transfer from your main checking account into your emergency fund.
- Save windfalls. Anytime you get a big chunk of cash, put some (or all) of it into your emergency fund. A tax refund, work bonus, inheritance, or some other unexpected cash can help boost your efforts.
- Cut expenses. Take a look at your spending and find ways to cut back. You can take the savings from trimming the fat in your budget and put it into your emergency fund.
At some point, you’re probably going to need to come up with a significant amount of cash in a short period of time. Whether you need to have your car towed or need to cover an emergency room copay, coming up with that money can be stressful if you don’t have an emergency fund.
As you get in the habit of saving and setting aside money for a rainy day, you’ll begin to feel more peace of mind — and you’ll be less likely to need debt for taking care of financial hiccups.