Everyone should have an emergency savings fund, no matter their financial situation. You must have one because it'll equip you to deal with unexpected expenses and emergencies, such as a job loss, medical bills, or home repairs.
It can be hard for people with other financial responsibilities (like paying off debt) to prioritize building an emergency fund. Even so, you should still make it a priority as it will protect you from turning to high-interest credit cards in times of unexpected expenses and racking up more debt.
Best of all, you'll gain peace of mind knowing you can deal with unexpected financial situations as they arise.
How much emergency savings should you have?
Generally, we recommend to have enough money saved up to cover three to six months of living expenses. This will give you a cushion if you lose your job or experience unexpected financial hardship.
Here's an example:
Let's say your monthly living expenses are $2,500.
You should aim to have at least 3 x $2,500 = $7,500 saved in your emergency fund.
By having a three month financial buffer, you should be able to handle sudden financial difficulties such as if you lose your job.
However if you can afford it, aim for six months of living expenses ($15,000) in your emergency fund.
It's best to err on the side of caution and save more than you think you need. At the same time, don't shy away from putting your income to other productive uses once you've saved up a sizeable fund.
Where should your emergency fund be saved?
Your emergency savings must be easily accessible in case of an emergency. Here are some things a to look for when choosing a place to keep your emergency savings:
- Easily accessible
- No minimum balance requirements
- No withdrawal fees
- Low risk
Good places to keep your emergency funds
With the requirements in mind, here are some good places to keep your emergency funds:
High-yield savings accounts
These accounts offer higher interest rates than traditional savings accounts, so you can earn more money on your emergency fund.
Money market accounts
These are similar to savings accounts but often have higher interest rates and the ability to write checks from the account.
Bad places to keep your emergency funds
Examples of bad places to keep your emergency funds are:
Certificates of deposit (CDs)
CDs are a bad place to keep your emergency fund because they typically require you to lock in your money for a fixed period of time, usually ranging from three months to five years. Additionally, CDs often have early withdrawal penalties which can reduce the amount of money you get back if you need to withdraw your funds before the maturity date.
Investing your emergency fund in the stock market is also not recommended, as the stock market can be volatile and you could end up losing money if the market takes a downturn.
How do you build an emergency fund?
Building an emergency fund is not hard, it just requires discipline and commitment. You can build your emergency fund in just six simple steps:
Step 1: Calculate how much you need using the example we gave earlier
Use the calculation we shared in the “How much should you save in your emergency fund?” section to determine how much you need. This will be your savings goal.
Step 2: Create a budget to see what you can put towards your emergency fund
Now you need to set a budget. This will give you a clear picture of your incomings and outgoings, which will show you how much money you can put towards your emergency fund each month.
Start by listing all of your monthly income sources and then list all of your monthly expenses.
Expenses include fixed expenses (such as rent or mortgage payments) and variable expenses (such as groceries or entertainment).
Once you have listed all of your income and expenses, subtract the total amount of expenses from the total amount of income. This is how much money you can put towards your emergency fund each month.
Here's an example:
Let's say you make $3,000 a month and your expenses are $2,500.
That means you have $500 left over each month that you can put towards your emergency fund.
If you want to save $9,000 in your emergency fund (3 month's worth), then it will take eighteen months of saving the extra $500 each month to reach your goal.
While you don't have to put the entire $500 towards your emergency fund, we recommend that you put as much money towards building it at this time. This is so you can establish it as quickly as possible. Your emergency fund is the foundation to your personal finances and it'll pay to have that in place sooner rather than later.
Step 4: Set a regular contribution and stick to it
Continuing our example from above, we now have $500 we could potentially put towards our emergency fund.
You could possibly put in $500 this month, and $400 next month, and whatever amount catches your fancy. But we recommend that you choose a regular contribution (say $500 each month), and stick to it.
Having a regular contribution allows you to plan ahead so you know exactly when you'll hit your savings goal. It makes it easier to stay on track, and helps you build up a habit of saving, which is an essential skill for financial success.
Step 5: Set up automatic transfers into your emergency fund savings account
Setting up automatic transfers into your emergency fund savings account is a great way to ensure that you are consistently saving money for your emergency fund.
By having the money automatically transferred from your checking account to your emergency fund, you won't have to worry about forgetting to make the transfer or spending the money on something else.
In fact, the habit of automating your finances will help you in other areas such as regularly investing, paying your bills on time, and saving for other goals.
Step 6: Make extra contributions when you have spare money
If you come across small windfalls such as a tax refund or birthday gifts, put that towards your fund. Making extra contributions when you have spare money is a great way to build up your emergency fund faster. Because an emergency fund is the foundation for financial success, it will be money well used.
What should emergency funds not be used for?
Sometimes people get confused about what an emergency fund can be used for. You'll probably get a clear idea once we tell you what it's not used for.
If you're still earning your regular income, you should not use it for everyday expenses such as groceries or entertainment. This includes regular bills such as rent or utilities. While these are necessities, you should be budgeting to pay for them from your income.
Paying off existing debt
Your emergency fund should also not be used to pay off existing debt. While you may be tempted to use any spare cash to ease the burden of debt, the purpose of emergency funds is to prevent you from taking on more debt.
Again, you should budget to pay off your debt from your income.
If you're interested in paying off existing debt, you're in the right place! That's what we're all about. Start with our guide on how to get out of debt.
Investing in opportunities
It's also not an “opportunity” fund. You might be tempted to dip into your emergency fund when you see an attractive investment opportunity, but again the emergency fund is for emergencies only.
What should you do if you use what's in your emergency fund?
If you use what's in your emergency fund, it is important to replenish the funds as soon as possible. You should set a goal for how much you need to save and then make regular contributions to your emergency fund until it is back up to the desired amount.
What do you do after you have reached your savings goal?
Once you have reached your savings goal for your emergency fund, you can continue making regular contributions to build beyond your savings goal – we feel that more is always better. You'll inevitably dip into your fund, so having some extra buffer will save you from scrambling to replenish it.
If you feel comfortable with how much you've saved, you can also allocate some of the funds to other investments such as stocks and bonds in order to diversify your portfolio and potentially increase your returns.
Bottom line: everyone needs an emergency savings fund
Skipping on creating an emergency savings fund is a big no-no if you want financial security. Unexpected expenses will happen and you need to be equipped to deal with them, or else you'll be taking on debt to pay for it.
Saving in your emergency fund is not complicated, but it's not easy either. You need to be disciplined with your savings, which can be a lot to ask for when you have other financial obligations.
However, keep your eyes on the prize – this “money cushion” will be instrumental to your financial success and the habits you build will serve you well in other areas of your financial journey.