Learning how to start an emergency fund is an important life skill. Instead of worrying about your car breaking down and shoring up funds for the repairs, a person with an emergency fund only has to worry about the first part of the problem. Although saving for an emergency fund isn’t as exciting as saving for a beach vacation, it can offer peace of mind when surprise expenses pop up.
What is an emergency fund?
An emergency fund is money set aside to cover unexpected expenses. Emergency costs could include a major car repair, medical expenses, a home repair, or a loss of employment. Emergency funds are typically held in accounts that are easy to access so people can quickly transfer money when necessary. The size of a person’s emergency fund may vary by salary, debt, and other aspects of their financial position.
Why is it important to start an emergency fund?
According to LendingClub, 54% of American adults live paycheck to paycheck, meaning most people can’t cover a major expense when disaster strikes. Even those with higher incomes aren’t always prepared: The same study revealed that almost 40% of individuals who earn six figures or more also live month to month. Learning how to build an emergency fund may help people avoid missing a bill payment, or worse.
Advantages of emergency funds
Building an emergency fund can prepare individuals for unexpected expenses and help them build better financial habits.
- Financial security. Individuals with an emergency fund may not be tempted to pursue other types of funding to pay for surprise situations, like charging a high-interest credit card.
- Flexibility in uncertain times. Job loss can be hard, but someone with an emergency fund can take their time to make a smart career move without worrying about making ends meet.
- Better financial habits. Someone who saves for emergencies may be more likely to watch their spending.
Disadvantages
Having an emergency fund is important, but it does have its drawbacks.
- Delayed saving elsewhere. Saving for an emergency may not be as motivating as saving for a Tesla or a trip to Thailand.
- Some sacrifice may be needed. Putting money aside for emergencies may mean curtailing the fun things in life, like weekend getaways or takeout for dinner.
When to use your emergency fund
Here are some common emergency fund examples:
- Medical or dental expenses not covered by insurance
- Car repairs
- Unemployment
- Home repairs
- Appliance replacements
- Time off or travel for a family emergency
Note: Ongoing maintenance, like routine dental exams, is typically not paid from an emergency account.
How to start an emergency fund
Learning how to start an emergency savings fund can be done in three simple steps.
Step 1: Determine where to keep the money
Emergency fund savings can be held in a bank account with little to no risk, like a high-yield savings account at a federally insured financial institution. Balances at banks and credit unions are typically insured up to $250,000.
Low-interest rates across the board make the term high-yield relative, as most banks offer a savings rate of less than 1%. However, every bit of extra earning power helps to grow that account balance while fighting inflation. Plus, transfers from a savings account to a checking account are fairly quick, especially when held at the same financial institution.
Step 2: Use an emergency fund calculator to find out how much to save
Everyone’s emergency fund will look different because no one has the same financial situation. When creating an emergency savings goal, there are several things to consider.
- How much is currently saved for an emergency? $500 is a common amount to start with, and can be added each month to grow that savings account.
- What would a bare-bones monthly budget look like? Ultimately, an ideal emergency fund will cover three to six months of expenses, in case an individual loses their job.
- What expenses may pop up in the near term? When saving for emergencies, an individual may look at current assets that may need attention in the future. For instance, it may be worth saving to replace that old roof before it starts leaking.
It’s important to understand monthly spending in order to make a realistic savings plan. A key step of any saving strategy is to look at personal spending, either manually through bank statements or with a budgeting app.
An online emergency fund calculator can be used to begin gauging how much to save. Questions ask about monthly expenses and provide a savings goal estimate at the end. These types of calculators take under a minute to use.
Step 3: Create a saving strategy
The next step is to set a timeline and determine how much money needs to be deposited into the emergency fund each month in order to meet that goal. This can be done by setting up automatic transfers and using unexpected windfalls (like a tax refund or credit) to beef up that savings account.
It’s worth noting that an emergency fund is a fluid account. As unexpected events pop up and the account holder uses some or all of the cash, the account needs to be replenished once the crisis is over.
Conversely, when an emergency fund is full, savers can turn into investors by continuing to set money aside to build wealth over time. It’s the next level up from being “financially prepared” to being “financially set.”
The bottom line
Creating an emergency fund is the first step to creating financial security. With healthy emergency funds, people are able to better focus on the actual situation, whether it’s a job loss, a family member passing away, or a medical emergency.
