What is an emergency fund?
A few months after buying our first home our water heater started acting up. I would wake up to find the pilot light was out and the water cold.
Which resulted in cold showers!
I had to bite the bullet and replace it. The old one was truly old, +20 years and it wasn’t up to code.
The cost: $1,000+ for the new unit and installation (only reason I didn’t perform the installation was due to it being a gas water heater – I don’t mess with gas, no bueno – on the flipside, a gas water heater is nice when the electricity goes out because you still have HOT water!).
Many of our friends asked us how we were able to handle the $1,000 in costs.
The answer: our emergency fund.
An emergency fund is a bank account with money set aside to cover large, unexpected expenses, such as:
- An emergency room visit.
- Home-appliance repair or replacement.
- Major car fixes.
- And, costliest of all, unemployment
One of the central tenets to good financial planning is preparing for the future, whatever it may bring. Therefore, an essential component of a solid financial plan is an emergency fund.
An emergency fund is designed to cover a financial shortfall when an unexpected expense crops up. Because it must be reliable, it needs to be liquid (easily accessible, withdrawn immediately) and hold guaranteed investments.
In other words, savings accounts are good for emergency funds, while stocks are bad.
Emergency Funds Dos / Don’ts
- Savings Account
- High Yield Savings Account (Preferred)
- CD (Certificate of Deposit)
- Retirement Accounts
Ideally, you won’t need to use the money in your emergency fund, and you will maintain it for the long-term.
Why do I need an emergency fund?
Having money in a high yield savings account can help you avoid borrowing. The financial buffer an emergency fund provides you can keep you afloat without having to rely on credit cards or loans.
This is especially important if you already have these obligations.
One of the first steps to climbing out of debt is to give yourself a way not to go further into debt.
How much should I save?
Prior to the financial crisis of 2008, personal finance experts recommended that your emergency fund contain three months’ worth of expenses. Now, new financial guidance is to have at least six months’ worth of expenses saved up.
A good rule of thumb is to have 3-6 months’ worth of living expenses.
Building an emergency fund can be difficult if you’re trying to get out of debt. One approach is to first build up $500-$1,000 emergency fund, and then redirect your efforts toward eliminating your debt. Once you’re debt-free, continue to build your emergency fund further.
The Emergency Fund “Calculation”
To figure out what you need, add up what you spend each month and multiply by six.
I know, NOT AT ALL!
If you don’t use one of these programs, hopefully, your bank provides an easy calculation, but most don’t. So you will have to sort it by expenses and add it up.
Make sure you include what you pay on your mortgage, utilities, car loans, insurance, groceries, and other essential expenditures (toilet paper, etc.). I like to include entertainment items and incidentals that crop up during the month as well.
Also, account for bills or other expenses that only come due once or a few times per year. For example, I pay my auto insurance semi-annually.
Emergency Fund Essentials
As I pointed out earlier, your emergency fund needs to be guaranteed. It must be liquid and accessible.
1. Low/No Risk
Unfortunately, investments often realize a rate of return that is directly proportional to how much risk they carry. This is why you’ll need to be satisfied with low-interest bearing accounts in your emergency fund. Checking and savings are the best choices.
The preferred choice is a high yield savings account — there are plenty that offer a 2.20% APY +
Just make sure your bank accounts or bank-guaranteed investments carry FDIC insurance.
This represents how quickly your assets can be converted to usable cash. A savings account, for example, is 100% liquid because it already is cash.
This is why cash products can be problematic. Such as CDs — come with penalties if you withdraw money early.
Luckily technology is on our side because a couple of years ago accessing my cash immediately could take three days. Which wasn’t soon enough.
Make sure you have a card linked to your savings or checking accounts to be able to access it instantly.
How do I build an Emergency Fund?
Calculate how much you want in your emergency fund (3-6 months of expenses) and figure out how much you can put in each month. Then, simply determine how long it will take to reach your goal based on your monthly contribution.
Breaking it down like this makes it more manageable and less daunting.
1. Set a monthly savings goal
This will get you into the habit of saving regularly and will make the task less daunting. One way to do this is by automatically transferring funds to your savings account each time you get paid.
Schedule regular payments from your checking account to your emergency fund, using automatic bill payment plans. You might be able to have some of your paycheck directly deposited into your emergency fund.
This way you don’t have to remember to do it yourself every month.
2. Use spare change
When you get a few dollar bills back from breaking a $5 or $20, drop it into a jar.
But let’s be realistic, most of us use credit or debit cards.
Luckily, there are a few fantastic automatic mobile savings apps that do it for you!
Automatic savings apps are an easy, reliable and foolproof method to hack your way to saving more money and putting towards your emergency fund.
Thankfully, technology has given us the ability to take personal responsibility out of the equation.
3. Use wasted money
Experts estimate that each household wastes at least 10% of its income each month.
This isn’t accidentally throwing money in the trash, this is money wasted on frivolous purchases or, simply leaving the lights on.
If you have a budget, you can determine where money can be unwasted and moved some into your emergency fund.
If there’s no money left, cut expenses. See which parts of your monthly spending you can trim, so you’ll have cash left over to build your fund.
Some ways to save include carpooling, cooking more meals at home, saving leftovers and avoiding small daily purchases such as coffee.
4. Save your tax refund
You get a shot at this once a year.
If you were able to live without this money all year, why not now?
Stash it away! Don’t think of your tax return as a bonus.
Saving it can be an easy way to boost to your emergency stash. When you file your taxes, consider having your refund deposited directly into your emergency account.
Alternatively, you can adjust your W-4 tax form so that you have less money withheld. Then direct the extra cash into your emergency fund.
Start Your Emergency Fund Today!
Get on a budget, pay off your debt, and begin saving. You’ll be amazed at how quickly your emergency fund piles up when you aren’t making debt payments! But the best part? You’ll feel an amazing sense of security.
If the roof leaks or the car breaks down, don’t be shocked if you end up thinking, Eh, what’s the big emergency anyway? That’s the peace of mind that comes with completing your emergency fund! It turns what would have been a major emergency into just a little inconvenience.