Life happens. And it happens fast.
When tragedy strikes, it can have a serious negative impact on your financial situation - be it big or small. So how do you prepare for the unexpected before it happens?
What is an emergency fund?
An emergency fund is money set aside to help you through unexpected events that can hurt you financially. Having an emergency fund can improve your financial security and minimize the stress of a job loss, temporary disability, or major repair.
Without an emergency fund, you may live in fear of crisis. And if an adverse event occurs, an emergency fund can protect you from having to use credit cards, take out loans, borrowing from your retirement account, or asking friends and family for help.
How much should an emergency fund be?
Financial experts suggest your emergency fund hold an amount equivalent to at least three months of take-home pay. Another rule of thumb is to have enough to cover essential expenses for three to six months in the event you have no income.
Stable income sources generally require less of an emergency fund. Two-income households can likely get by with a three-month fund.
On the other hand, a one-income family should try to put aside six months of income. Six months should also be a goal for those who have irregular incomes, such as the self-employed or those working on commission.
Other scenarios in which you might want to save more include:
- A member of your household with a chronic medical condition
- Recessionary periods in which it may be more difficult to find work
- Working in an industry where layoffs are more common
- If you’re retired or nearing retirement
To determine your emergency fund amount, add up the expenses you have to pay no matter what. These include:
- Health care
You don’t need to include discretionary spending, such as vacations, entertainment, money you save or invest, and nonessential purchases. These are expenses you can do without during a time of unemployment, disability or other adverse event. Once you’re back on your feet, you can put these expenditures back in your regular budget.
Once you determine your monthly essential expenses, multiple it by three to six months based on how much you feel the savings should last.
There are also online calculators to help you determine an emergency fund amount, such as Nerdwallet.
How to build an emergency fund
Building an emergency takes financial discipline. You have to make it a priority and set aside the money when you get paid. And you need the restraint to avoid withdrawing what you’ve saved for things that aren’t emergencies.
A good place to start is making a budget and sticking to it. Have a line item for emergency savings. Treat it as a bill that needs to be ‘paid’ each week or month. A budget will help you determine how much you need to have saved in an emergency fund. It also helps ensure you don’t overspend, which can hinder your ability to save your emergency fund.
Set a weekly or monthly savings goal. Something is better than nothing. You can build your emergency fund by stashing small amounts on a regular basis. Over time, the fund will grow.
For example, saving $50 a week will get you $5,200 in two years, while $75 weekly contributions will add up to $7,800.
As you’re able, increase how much you save to grow your emergency fund faster. It's also a good idea to use any extra income, such as a bonus or tax refund, toward your emergency account until it’s fully funded.
If you find it difficult to build your fund, you may want to consider taking a part-time job or starting a side business to make extra money. Another way to contribute to your emergency fund is to sell some of your valuables and unneeded items.
Where to put an emergency fund
An important part of saving an emergency fund is to have money that is accessible, but not too accessible.
When an emergency arises, you want to access your extra cash right away. But you don’t want it so convenient that you’re tempted to dip into it for a new TV, vacation, or an expensive gift.
You also want to keep your emergency fund out of risky investments that could lose value, such as stocks and mutual funds. After all, saving for emergencies won’t do much good if it’s not there when you need it.
At the same time, you should look for options that can earn some interest on your emergency savings.
Savings vehicles that meet this criteria include:
High-yield savings account. While regular bank savings accounts typically earn less than 1 percent interest, some high-yield savings accounts offer rates of 2 percent or more. Keep in mind that some high-yield accounts require a minimum deposit amount.
Money market account. This is a type of savings account that offers some of the flexibility of a checking account. This type of account typically pays higher interest than regular savings and checking accounts. However, there are higher minimum balance requirements and limited transfers and withdrawals. Money markets also generally have fees attached.
Certificate of deposit. CDs require savers to keep funds in the account for a specific time period until a maturity date. In return for keeping your money locked up, the financial institution pays a higher rate of interest than offered by regular savings accounts. CDs also typically have higher minimum-deposit requirements.
Treasury bills. These are short-term debt obligations of the U.S. government. You buy them for a set amount and the Treasury pays you a higher amount at a designated maturity date. Although interest is only paid at maturity, you can sell Treasury bills before they mature if you need to access the cash for an emergency. You can purchase them directly from the Treasury Department, or though a bank or broker.
When to use an emergency fund
Once you’ve accumulated an emergency fund, it’s critical to preserve it. It should never be a source of money for unbudgeted expenses that you wouldn’t consider an emergency.
Experts strongly suggest you only use an emergency fund for instances that are unexpected, necessary and urgent. Emergency room visits, major home and car repairs, and necessary but unplanned travel expenses (e.g. having to travel for a funeral) are acceptable uses for an emergency fund.
The size of the expense shouldn’t necessarily make it an emergency one, especially if it’s one you can anticipate. For example, paying a tuition bill, buying a new computer, or paying for a wedding should not be uses for an emergency fund, since you can plan for these and save money in a different account.
The most common use for emergency funds are instances where you’re out of work and not earning income, like being laid off or terminated.
Another example is missing work due to an injury or illness that limits your ability to earn a living, whether temporarily or permanently.
Even if you have disability insurance, it’s a good idea to have an emergency fund to help you through a disability period. That’s because most policies have a waiting period, also known as an elimination period, during which you will not receive policy benefits.
Your emergency fund can help pay your necessary expenses during your disability policy’s waiting period. This is the period of time between when the disability occurs and when benefits are paid. For example, a policy with a 60-day waiting period would not pay benefits for the first 60 days after the insured becomes disabled.
Joel Palmer is a freelance writer and personal finance expert who focuses on the mortgage, insurance, financial services, and technology industries. He spent the first 10 years of his career as a business and financial reporter.
The information and content provided herein is for educational purposes only, and should not be considered legal, tax, investment, or financial advice, recommendation, or endorsement. Breeze does not guarantee the accuracy, completeness, reliability or usefulness of any testimonials, opinions, advice, product or service offers, or other information provided here by third parties. Individuals are encouraged to seek advice from their own tax or legal counsel.