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Guide To Creating an Emergency Fund

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An emergency fund provides a safety net in times of financial uncertainty. With recent major events such as the global COVID-19 pandemic and an economic downturn that followed, dipping into emergency savings was a necessary response for many households. Research shows that Americans are eager to save and of those that didn’t have emergency savings before the pandemic, 47.3% now plan to build their emergency savings

This guide can help you navigate the ins and outs of building an emergency savings fund and how to get started.

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What is an emergency fund? 

An emergency fund is savings intended for unplanned or unexpected expenses, such as medical bills, loss of income or major home or vehicle repairs. It’s intended to provide a cash resource to help you get through a financial emergency.

Why do I need an emergency fund? 

father placing newborn baby on scale
Unsplash

Having a solid emergency fund can serve as a much-needed lifeline during emergencies while at the same time helping you to avoid borrowing funds at high interest rates, which can lead to expensive debt.

Besides unexpected medical emergencies and car repairs, an emergency savings comes in handy in a number of scenarios: 

  • You’re starting a family: Parents know that there are many unplanned expenses when a baby comes along, whether this is unplanned extra days spent in the hospital or deposits for childcare. 
  • You own a home: Being a homeowner means you’re responsible for home repairs and maintenance costs. It also means paying for many other hidden costs of owning a home, and that’s where an emergency fund can come in handy to cover those expenses.   
  • You want to stop using debt: When you don’t have emergency savings, there’s a good chance you’ll have to use debt such as credit cards to serve those unplanned financial needs. If you are not paying your balance off every month, that debt can be expensive due to the high interest rates of credit cards. To avoid this, you’ll need a savings cushion.
  • Your income is not stable: Whether you’re self-employed or have a part-time job, there are going to be those months where you might not have an income, or where your income is reduced. An emergency fund can provide a safety net to help you get through the tough times.
  • There’s only one earner in your household: Whether you live on your own or with a partner, finances can become complicated during financial emergencies when you’re the only one bringing in income.

No one can predict the future, so having something saved up for a rainy day can provide peace of mind for many families.

How much should I have in my emergency fund? 

There isn’t a set figure that will work for everyone as the amount will depend on your personal financial situation, such as your usually necessary expenses, income, how much you can save, how many dependents you have, and your financial goals. That said, covering your expenses for a few months is a good place to start.

Most financial experts would advise having around six months worth of living expenses saved up as an emergency fund. However, if that seems out of reach, start saving every month with an amount that’s within your budget and work on growing the fund at a rate that you’re comfortable with.

Where do I put my emergency fund? 

man getting money out of atm
Pexels

There are a number of options that can be used to build up your emergency savings. Consider accounts that meet the following criteria: 

  • Low-risk or no-risk account 
  • Instant or quick access to your funds 
  • Minimal withdrawal or penalty fees 
  • An account that bears interest
  • Federal Deposit Insurance Corporation (FDIC) insured

It’s important to choose the account that suits your needs, as each provides different features and benefits. Here are several options to consider.

Simple Checking or Savings Account 

If you’re reluctant to tie up your funds for any period of time, a simple savings or checking account may be an option. There are free checking accounts and savings accounts that require low or no minimum opening deposit, which is a great option for those just starting to build their emergency fund. 

A simple checking or savings account offers easy withdrawal of money at any time, but it can also be tempting to spend the money on things that aren’t necessarily an emergency. You could mitigate that temptation by not getting a debit card connected to your account. 

High-Yield Savings Account 

High-yield savings accounts are bank accounts designed to offer you a higher return than regular checking or savings accounts. Some important things to consider when opting for a high yield savings account are: 

  • The rate: The competition is fierce with these products and it’s not unusual to earn 10 or more the national average in returns. Here are some of the best high-yield savings accounts to consider.
  • Minimum balance: For the higher yield accounts, some banks may require you to have a minimum opening deposit or daily balance. If you want to access all your funds and you end up dipping below that minimum balance, you may not earn interest and the bank may even decide to close your account.
  • Fees: Check to see if there are monthly account fees or other transactional fees. In some cases, the monthly fees may be waived if you meet certain balance requirements.
  • Accessing funds:  Make note of withdrawal restrictions and all the steps it takes to get funds when you need them.

While high-yield savings accounts provide good returns and relatively quick access, those who don’t need instant access to their funds may have a few more options. 

Certificate of Deposit (CD) 

A Certificate of Deposit is a type of savings account that holds money for a fixed period of time. While you might earn more with a CD, it comes with much less flexibility. Still, this may still be a viable option for those who have access to other savings pockets and may not need instant access to funds in the short term. CDs are term accounts where you can generally enjoy higher rates the longer the fixed period of time.

Terms for CDs range from just a few months to five years and longer. For emergency savings, this might not be the best option as access to the funds before the end of the term may result in penalty interest. The fee may be worth it, however, if it is a true emergency. If you’re concerned about yield but you also don’t want to tie all your funds into one CD, consider having multiple accounts with different terms to improve your access. 

Money Market Account 

These accounts are another type of savings deposit account that offers instant access to funds while offering accountholders checking features such as debit cards and checks. The rates offered on a money market account may be slightly more than a high-yield savings account, but some of these accounts may require a substantial opening deposit. 

Money market accounts will usually have a cap on the number of monthly transactions, which may discourage you from withdrawing money frequently out of the account. They may also have transaction fees and additional fees may be levied if the account balance dips below a certain amount. Check out some of the highest-paying money market accounts currently.

Individual Retirement Accounts (IRA)

Saving up an emergency fund in a retirement account may be considered an alternative emergency savings solution but there might be tax implications for early withdrawals, unless the emergency meets hardship requirements that are exempt from early withdrawal penalties. Plus, a nest egg could lose money if there is a down turn in the market. However, for those who are able to leave funds in the account and ride out the market fluctuations, the account might earn a better return than the below-inflation savings options.

Health Savings Account (HSA) 

Medical expenses can be a big financial drain and is a big reason to fund an emergency savings plan. A Health Savings Account (HSA) works as a type of savings account that lets individuals contribute pre-tax money towards eligible medical expenses. The funds are accessible and the withdrawals are tax free as long as the proceeds are used towards qualified medical costs such as deductibles, copays, medical procedures, etc. 

HSA accounts are only available to those who are enrolled in a high deductible health plan (HDHP). Non-qualified expenses may have withdrawal penalties of around 20%, and these withdrawals may be taxable. 

How to Create an Emergency Fund

couple budgeting at home
iStock

Here’s a general guide on how to get started on creating an emergency fund.

Step 1: Create a Budget 

One of the first steps in building up an emergency fund, is by knowing just how much of your income you are able to contribute. Start by creating a budget and a financial goal. Determine your monthly expenses and how much you can afford to save each month to get started.

Step 2: Identify the Savings Vehicle 

Once you know how much you can put away, decide on the type of account that will house your emergency savings. Evaluate the risks of each account and pick the one that fits your needs.

Step 3: Open the Account 

Whether this is an online application or a visit to the brick and mortar, the entire process shouldn’t take more than a few minutes. 

Step 4: Fund the Account     

You can either make manual payments to the emergency savings, or you can automate your contributions in order to streamline the savings process. General guidance is to aim for at least six to 12 months of living expenses including rent and necessary living costs.  

Step 5: Look for Opportunities to Increase Your Savings 

Creating additional savings can come from taking a closer look at your budget. Whether you cut back on expenses, pay off debt, or increase your income, there may be pockets of cash you can add to your monthly savings contributions. For example, some banks and apps offer tools that allow you to round up on purchases, putting the additional money paid for each transaction into a saving account.

Step 6: Separate Your Emergency Savings from Your Spending Accounts 

One of the best ways to try and prevent yourself from dipping into the savings, is to create some distance between your savings and your daily cash flow. Consider keeping an emergency fund in a separate bank account to help ensure you don’t use your emergency for everyday purchases. 

Emergency Fund FAQs 

Should I use my emergency fund to pay off debt? 

This will depend on the specific situation, such as how much debt there is and how much money there is in the emergency fund. In instances where an individual has credit card debt at a high interest rate, it might make sense to pay off the debt if there is enough in the emergency fund to cover the cost. If using up all of the emergency fund will create a huge financial setback, it may not make sense to pay off debt using the funds. 

Is $1,000 enough for an emergency fund? 

Having $1,000 can be a good launch pad for an emergency fund and could be enough to cover smaller emergencies such as a flat tire or quick visit to the urgent care.  But it is likely not sufficient to cover several months of expenses in a worst case scenario. Continue to add to your emergency savings until you can cover at least six months of expenses.

How do I calculate how much to save for an emergency fund? 

A quick option is to simply base the emergency savings on several months of essential expenses, such as rent and everyday living costs. That means if you have expenses of $1,500 per month and you’re looking to save up six to 12 months’ worth of funds, you’re looking at $9,000 ($1,500 x 6 months) to $18,000 ($1,500 x 12 months) in an emergency fund.

For those living paycheck to paycheck, even putting aside a little every month can go a long way over time. Just know it will take more time to reach your goal.

Do I need 12 months of emergency funds? 

That will depend on the individual, but those who want the most financial security should aim for 12 months of an emergency fund. It’s hard to determine how long it will take for a financial crisis to resolve, so having at least a years’ worth of money can be helpful in many scenarios. 

Other things to assess when deciding your emergency fund strategy is to look at other financial factors such as job security, access to cheap and fast credit, friend or relative financial support structure, and more. Some individuals may even consider continuing to add to an emergency fund once they have a years’ worth saved up. This can provide even more of a cushion in a crisis. However, 12 months is a solid target and at that point individuals may want to adjust their savings strategy to be less aggressive.

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