Every now and then, something happens that puts a strain on your wallet. An appliance breaks down, the car needs maintenance, or you end up traveling for a family emergency. When this happens, an emergency fund can help you manage the cost while limiting the amount of debt you end up with. If you're hoping to get on a firmer financial footing, here's what you need to know about emergency funds.
What Is an Emergency Fund?
Emergency funds are designed for, well, emergencies. Your emergency fund is where you keep a chunk of accessible money that you can use in a pinch. You build up an emergency fund so that when you need a couple of hundred dollars to buy a new appliance – or even enough to get through a few weeks of lost work – you don't have to use credit cards or other types of debt.
Tapping into your emergency fund should be reserved for times when you truly need the cash and don't have it readily available in your other accounts.
Some of the benefits of having emergency money include:
- Reducing your chances of being overwhelmed by debt as the result of an emergency
- Preparing for unexpected financial setbacks
- Peace of mind because you don't have to worry as much about where you'll get the money
Where to Keep an Emergency Fund
For the most part, emergency funds should be accessible quickly and easily. This means keeping them in a liquid account that you can tap into when it's truly needed.
Many experts suggest keeping a significant portion of your emergency fund in a high-yield savings account. The account should pay a fairly high annual percentage yield (APY), and it should be FDIC-insured so that you know it's relatively safe. Here are our favorite services:
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Consider choosing a savings account that's connected to your checking account so that you can easily move money from one account to another. Realize, though, that federal regulations limit how many transactions you can make from a savings account in a month, so pay attention in case you need to access your account more than the maximum times allowed.
How to Build an Emergency Fund
For the most part, you build an emergency fund over time. There's a good chance you won't be able to fully fund your emergency account with one deposit. Instead, you need to figure out how to build your emergency fund over time. Here are the steps you can take to build an emergency fund.
1. Calculate the Total That You Want to Save
Your first step is to figure out how much to save. Many experts recommend that you base the size of your emergency on your monthly expenses.
- Figure out how much you spend on the necessities each month.
- Then determine how many months' worth of expenses you want to save up.
- The rule of thumb is three to six months' worth of expenses, but some people are more comfortable with a larger amount.
2. Set a Monthly Savings Goal
Once you know the total, you can set a monthly savings goal to help you reach your objective. For example, if you figure that you spend $4,000 a month on necessities and you want five months' worth of expenses saved up, you need $20,000 in your emergency fund.
Review your budget and decide how much you can set aside each month. Maybe you can set aside $300 per month to start. Do that. It might seem like it will take a long time to reach your goal, but in the meantime, you'll be building up an emergency fund that you can draw on later. Any amount you save can be used to benefit you later – even if you're not quite to your total.
3. Put Extra Money Toward Your Emergency Fund
When you get extra money, put it toward your emergency fund goal. For example, some apps round up your purchases and deposit that amount into an account. You can put that spare change toward building your emergency fund.
You can also put windfalls toward your goals. Save your tax refund (or at least part of it) in your emergency fund to get to your ultimate goal faster.
You can also assess and adjust your contributions. Maybe after a few months, you realize that you could be setting aside $500 per month instead of $300 per month. Boost your monthly contributions so that you get more money into your fund faster. This leads to increased peace of mind as well as putting the goal within reach sooner.
4. Make It Automatic
Finally, make it automatic. The most successful emergency funds are those that are prioritized. Set up an automatic transfer from your account each month so that it goes toward building your emergency fund. If you're concerned about taking out one chunk each month, you can set up weekly transfers to better smooth your cash flow.
Also, make it an automatic reflex to put money into your emergency fund when you get a windfall. You should automatically think that a certain percentage of a work bonus, tax refund or gift will immediately go toward building your emergency fund.
Emergency Funds and Investing
It's also possible to invest a portion of your emergency fund. While this can be a way to potentially improve your returns, it's important to understand the risks involved with emergency funds and investing.
When you put some of your emergency fund into a brokerage account, you may get a higher return than you'd see with a savings account. Some consumers like this because it allows your money to do more for you and your portfolio will grow faster. Robo advisors could be an excellent choice for investing some of your emergency funds. Here are some our favorites:
On the other hand, there is the risk of loss with investments and you could end up having to sell your investments at a loss if an emergency strikes when the market is down. You may be able to use tax-loss harvesting to offset the impact, but it can still be difficult to accept the potential capital losses.
If you decide to put a portion of your emergency fund into an investment account, consider using a tiered approach. Keep four to six weeks' worth of expenses in a safer savings account that can be accessed immediately while you liquidate other assets for a larger emergency. Also, have safer investments, such as bonds, and reduce the number of stocks you include in your emergency fund.
How to Rebuild Your Emergency Fund
Finally, once you've dipped into your emergency fund, you need to figure out how to rebuild it later. Here are some fast ways to restock an emergency fund after an emergency:
- Create a budget designed to help you get your finances back on track.
- Go on a short-term spending freeze and put the savings toward rebuilding your emergency fund.
- Sell some items you no longer need and put the proceeds toward getting your emergency fund back up to its desired level.
- Start a side hustle or work extra hours to boost your income and put the extra money toward your emergency fund.
At the very least, you should get back on track with your old monthly goal of saving.
Everyone Should Have an Emergency Fund
For many people, emergency funds are a way to cope with the unexpected while building a solid financial foundation. But actually, we should all have an emergency fund. Life can be tough at times, and it's better to know you can afford those unexpected emergencies. With the right planning, you can build an emergency fund that protects you.