In this article, I'm going to cover what an emergency savings account is, what it's for, how to start one, how much to put in it and when to use it.
An emergency is pretty much any unexpected expense that needs to be dealt with right away. Having faced a broken down car myself, I know that it can be an expensive surprise. If you aren't prepared, an emergency can completely derail your household finances.
But about 40% of Americans didn't have enough savings to cover $400 worth of unexpected expenses, according to a Federal Reserve study.
Keep reading to learn how and why to stop being part of this statistic.
An emergency fund is a savings account you use to hold extra cash in case of unexpected expenses that can't be put off. Emergencies range from the broken-down car like mine, a lost job or a personal injury. Unfortunately emergencies like these happen to people every day, which means a rainy day fund can be a real lifesaver if you find yourself in this situation.
The purpose of an emergency fund is to be able to pay for an unexpected expense without taking on new debt. The last thing you want is to be in a financial crisis after an emergency. Set aside some emergency money so you can always have financial security no matter what life throws at you.
If you're one of the 78% of Americans living paycheck to paycheck, according to a CareerBuilder report, an emergency could put you in the position of skipping groceries or even your rent.
To avoid going hungry or risking their housing, some people turn to payday loans or borrow from credit cards at high interest rates. If you don't already have the money to pay them back, using a payday loan or even a credit card to cover an emergency puts your future financial stability at risk, costs you more money and makes it even harder to save money to avoid another financial emergency.
So do you need an emergency savings fund? Yes, you probably do. Do your best to pay for emergencies from savings, not credit.
Everyone earns and spends different amounts of money, so you shouldn’t assume your emergency fund should be the same as anyone else’s. For most people, the best rule to follow is to keep a minimum of three to six months of expenses saved in an emergency fund.
The average US household spends about $60,000 per year, or $5,000 per month, according to 2017 Bureau of Labor Statistics data. If you spend $5,000 per month, you should have at least a $15,000 emergency fund if you have stable employment, or $30,000 if you are self-employed or your income is more variable.
If a $15,000 emergency fund sounds impossible, don’t worry, start saving whatever you can. With the average car repair coming to $500 to $600, according to AAA, consider making that your first milestone.
Over time, you’d be surprised how much even small savings contributions can grow. For example, if you saved just $5 per week, you could have $240 by the end of the year.
It’s not $15,000 – but it’s a start.
If your emergency fund is mixed in with your other bank accounts, you may be tempted to spend the money on something else.
Remember, there’s a difference between saving for the purpose of buying something and saving money to use in case of emergency.
Keeping a separate emergency fund might also earn you more money in interest. Instead of your regular checking account, which could charge fees, consider moving your emergency fund to a high-yield savings account that pays you the most possible interest.
You should use your emergency fund to cover medical, housing or transportation-related emergencies. If you unexpectedly lose your job, you can also use your emergency fund to cover living expenses like utilities, groceries and rent or mortgage.
You shouldn’t use your emergency fund for “wants” like vacations, electronics and meals out. Instead, the cash should be kept only for true emergencies.
If you have struggled with money in the past, your growing savings account balance could create temptation. When you earmark cash for an emergency, try to avoid gray areas that feel like an emergency but really are not.
For example, you may plan to use your emergency fund to pay for car repairs. But what do you do if your car breaks down and you decide it may be better to replace the car than fix it? If your car is broken down beyond repair and you need a car to get to work, then perhaps replacing your car is an emergency.
However, if spending a couple hundred dollars from your emergency fund could save you from wiping out your fund completely and allow you to postpone buying a new car until you can save for the down payment, it might be better to just get the car fixed.
If you’ve decided to keep an emergency fund, you need a place to store it! Your current bank might be the most convenient, but it isn’t always the right choice.
Consider opening a new, online savings account at a bank with a high interest rate. Another option could be a money market account, depending on your goals and situation. For most people,though, a regular savings account works great as an emergency fund.
Using a savings account for your emergency fund ensures your money is FDIC insured, earns the best interest rates possible. Keeping your emergency savings separate from your daily checking account also means you can't “accidentally” tap into your emergency fund account for other purposes.
Popular banks for this type of account include Ally Bank, Capital One Bank, Citizens Bank, Marcus from Goldman Sachs, American Express, Discover and Alliant Credit Union. Once you open and link your account online, you can transfer funds back and forth for free with just a few clicks.
When opening a new savings account, make sure the account doesn't charge recurring fees and doesn’t require a minimum balance. Those are firm rules I hold to for any personal bank account I use myself.
Bonus? If the account doesn’t require a minimum balance, you could start your savings with as little as few dollars.
If you’re running on a thin monthly budget, saving thousands of dollars might sound insurmountable. But don’t fret, you’ve got this. If you have enough cash to buy a few coffees each month or go out to see a movie, you can start an emergency fund.
If you can come up with just $5, $10 or $20 per month, you can set up an automatic recurring transfer from your checking account to your emergency savings account every month (do it weekly so you can see and feel the progress more quickly). Once you are done covering your monthly expenses, set aside some extra cash so you can have a rainy day fund.
Set up an automatic transfer that matches your pay schedule and you won't even notice that you don't have the money to spend. It will just go into savings and you won’t have to worry about a thing.
For people who get paid by direct deposit, you may be able to split your direct deposit into two accounts. I used to do this to save for retirement and other goals. Contact your manager or HR department to find out if this is an option for you.
Another option for kick-starting your emergency savings account is to use your tax refund for your first deposit. If you get extra money you weren’t expecting during the year (like a bonus, raise, extra part-time job, gitft, etc.) you can put that money towards your emergency savings goal.
Don’t have $400 in savings but have a credit card you can use to cover an emergency instead?
While it can be tempting to just charge an emergency on your credit card and pay it off over time, this approach means you add the cost of interest onto what could already be a costly expense.
If you’re not able to pay your card balance off immediately, and only pay the minimum amount due each month, you could be paying for that emergency for years to come.
According to the example below, if you have a credit card debt of about $6,000 and only pay the minimum balance due, over time you could end up paying more than $4,000 extra in interest alone!
Having an emergency fund set up could help you limit or avoid extra interest charges and credit card debt.
Just like you need health insurance, car insurance and homeowner’s or renter’s insurance, you need a backup plan for surprise expenses or a loss of income. With an emergency fund standing by, you'll have a lot less to worry about. So I encourage you to start to build an emergency fund today.
Eric Rosenberg is a former bank manager and corporate finance worker. His work is featured at Business Insider, Credit Karma, The Balance, Investopedia, and many other fine websites and publications. See Eric on Linkedin and Twitter.