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An emergency fund is a source of funding on which you can rely when life throws you lemons. It is a cash reserve that you allocate strictly for when unexpected, costly and urgent issues arise. Such issues do not include dire wants, such as a new television or a pair of shoes but rather, true emergencies, such as the following:
- Unexpected car repairs
- Unexpected home repairs
- Job loss
- Personal injury
- Unanticipated medical care
- Sudden death of a loved one
In these situations, you may find yourself in dire need of a large amount of cash to quickly cover unexpected expenses. This is where your safety net comes in handy.
Since the unexpected can happen in the blink of an eye, and can potentially turn your whole world upside down, your ability to react appropriately and to move forward in the most efficient manner possible depend largely on your financial security at the time of the triggering event. While you do not necessarily need to have wealth to respond to emergencies appropriately, you do need to have an emergency fund.
Why Do You Need an Emergency Fund?
Without a dedicated savings account, even a minor emergency can set you back substantially. Too many people rely on credit cards, personal loans and other forms of financing to see them through tough times. While there is a time and a place for loans, borrowing money to cover small but unexpected expenses can quickly add up to a mountain of debt.
Before you know it, you may have a $500 credit card balance here, an $800 loan balance there and a $300 balance with a family member. Not only must you now pay down $1,600 to cover what could have been minor expenses but also, you must pay interest. Interest makes it difficult for already financially-strapped individuals to keep up, as interest payments can make up a weighty amount of the minimum monthly payment on many accounts. If you already live on a tight budget, financing emergencies can eventually force you to pull money from other sources of savings, such as your high-yield savings account or certificates of deposit. Not only does this cause more stress in your life but also, it compromises your long-term savings goals.
When you have a dedicated emergency bank account, however, you can cover unexpected expenses with cash. This prevents you from racking up costly debt and keeps your money worries at bay.
How Much Do You Need in Your Emergency Fund?
When kickstarting your emergency fund, it's a good idea to begin with a small amount. If you can allocate just $500, it should suffice for covering minor vehicle repairs, missed work days, or unexpected medical expenses. By depositing this amount into a high-yield savings account or an interest-bearing checking account, it can gradually grow over time.
Now, what if you're unable to allocate $500 towards the fund? No worries, emergencies are rare for most people. By setting aside even a small portion of your monthly paycheck, such as $50 to $100, you can build a safety net of $600 to $1,200 within a year. And if you use an interest-bearing account, that amount will continuously grow.
Ideally, though, it's best to aim for saving enough to cover three to six months' worth of living expenses. This will provide a safety net to safeguard you during periods of job loss, personal injury, or other financially challenging situations.
How To Build an Emergency Fund
The best and only way to build an emergency fund is to start saving. Whether you open a separate checking account that you plan to use strictly for emergency purposes or need an account with less accessibility, establish a separate source in which to keep your funds. Once you do that, do the following.
Set Feasible Savings Goals
Sure, it would be nice if you could contribute $500 to your emergency fund each month. Then again, if you could do that, you could cover the cost of an emergency out of pocket. Assuming you, like many other Americans, live on a tight budget, start with small, manageable goals. For instance, instead of saying you want to save $500 in the first month, plan to set that much aside by month four. This would mean setting aside $125 per month, which is doable for many people. Once you accomplish your first goal, up the ante by striving to save another $600 within the next four months.
Automate Transfers
It’s hard to miss money you never had, which is why you should automate your savings goals in some way. For instance, have your employer deposit a portion of your paycheck into a separate account on your behalf. If he or she cannot do this, set up reoccurring transfers between your checking account and savings account.
Save Leftover Cash
If you ever have money left in your go-to checking account at the end of a month, transfer it to your savings. You didn’t need it last month and chances are you will not need it in the next one. While you may be tempted to splurge simply because you can, putting that money aside will prove far more rewarding in the future.
Keep the Change
More checking accounts today offer the ability to automatically transfer the difference between the change of a transaction and the next whole dollar to a linked savings account. What this means is that every time you swipe, you save a little more. If your bank doesn’t offer this capability, there are dozens of free money-saving apps that do.
Invest Your Tax Return
Your tax return offers an easy way to bolster your emergency fund by hundreds to thousands of dollars in one fell swoop. Instead of using your tax return to fund your spring break vacay or to purchase that high-tech espresso machine, put it towards your future. Doing so may not be instantly rewarding, but it will pay off when you can pay for unexpected expenses out-of-pocket.
Be Kind To Yourself
All work and no play makes Jack a dull boy — and may discourage your motivation to save. Once you hit your various goals, celebrate. Take yourself out for a cup of coffee, buy that cheeseboard or say yes to that (affordably priced) dress. Small rewards for your efforts can give you the motivation to keep going.
While it’s crucial to save for a rainy day, it’s understandable that sometimes you just can’t. When emergencies crop up last minute, or when they cost more than what you have stored away, investigate credit products and services that have favorable terms and conditions.