What is an Emergency Fund?

what is an emergency fund?

By Eric Rosenberg

What would you do if your car broke down on the way to work tomorrow? Having faced a broken down car myself, I know that it can be an expensive surprise. If you are not prepared, a $400 emergency can completely derail your household finances.

But, according to a recent study released by the Federal Reserve, about 40% of Americans couldn’t afford $400 worth of unexpected expenses from savings.

An emergency fund is a savings account you use to hold cash in case of emergencies. Even though many people are not financially prepared, emergencies happen every day. That’s why you should follow these tips to build the ideal emergency fund for your unique needs.

Why do you need an emergency fund?

Broken down cars are just one example of when you might need quick cash for an emergency. Surprise illnesses, injuries, job loss, car accidents and home repairs are all common emergencies you’ll probably deal with at some point in your life.

While you hope to avoid emergencies, their very nature means you have to prepare in advance for the unexpected by having a safety net in place.

If you don’t have savings for an emergency, one of these surprises could mean you can’t pay the rent or can’t put food on the table. A 2017 report from CareerBuilder found that 78% of Americans live paycheck to paycheck.

Building an emergency fund is the first step in breaking that cycle.

When they run out of money, some people go to very expensive payday lenders or borrow from credit cards at high interest rates. Do your best to pay for emergencies from savings, not credit.

Why emergency fund savings need to be separate

If your emergency fund is mixed in with your other bank accounts, you may be tempted to spend the money on something else. You shouldn’t use your emergency fund for “wants” like vacations, new TVs and expensive meals. Instead, the cash should be kept only for true emergencies.

Remember, there’s a difference between saving up 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.

Deciding how much to save in an emergency fund

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.

For self-employed workers, contractors and freelancers, consider doubling that to a minimum of at least six months of expenses saved.

Forget about your income for a second and look at your total monthly spending. That’s easy if you have a budget. If you don’t already have a budget, you should make one!

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, your emergency fund should be at least $15,000, if you have stable employment, or $30,000 if self-employed.

If $15,000 sounds like an impossible amount, don’t worry, start with saving whatever you can.

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.

save $5 per week

It’s not $15,000 – but it’s a start.

Good uses of an emergency fund

The most common emergency expenses most people face are either medical, housing or transportation-related. On the flip side, however, you could also run into a surprise layoff or job loss. In that case, you might need to tap into your emergency fund to cover regular living expenses.

Personal finance is personal, so it’s up to you to decide what constitutes an emergency. Just keep your wits about you and never lose your long-term focus and you should be safe.

When to avoid using an emergency fund

If you have struggled with money in the past, seeing a growing savings account balance could be a huge spending 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.

Where to keep an emergency fund

If you’ve decided to keep an emergency fund, you need a place to store it! However, don’t rush to open up a new account at your current bank. While it may be the most convenient, that isn’t always the right choice.

Instead, 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 situations. But for most people, a regular savings account works just great.

Using a savings account ensures your money is FDIC insured, earns the best interest rates possible and is kept far enough away from your daily checking account that you don’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, Amerian 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 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.

How to start a new emergency fund

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, 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 fund every month (or do it weekly so you can see and feel the progress more quickly).

You can set up a transfer that matches your payday schedule and it will never feel like the money came and went. 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. Or if you get any extra money you weren’t expecting during the year (like a bonus, raise, extra part-time job, etc.) you can also put that money towards your emergency savings goal.

Why not just use a credit card to pay for emergencies instead?

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 debt of about $6,000 on your credit card and only pay the minimum balance due, over time you could end up paying an extra $4,000+ in interest alone!

Screen Shot 2019-07-23 at 2.02.36 PM

Having an emergency fund set up could help you limit or avoid extra interest charges and credit card debt.

Be prepared for the unexpected

Just like you need health insurance, auto 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 won’t have anything to worry about.

After hitting your emergency fund goal, you can sit back, relax and stand up to just about any financial emergency that crosses your path. So I encourage you to start to build an emergency fund today.

About the author

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.

Written on September 3, 2019

Self is a venture-backed startup that helps people build credit and savings. Comments? Questions? Send us a note at hello@self.inc.

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