Everything You Need to Know About Building Your Emergency Fund
If there is anything that 2020 can teach us, it’s that life is full of surprises. If you would have told me in January that a virus would totally shut down the world and that by the end of March I would be living under “lockdown” orders, I would have said you were 100% crazy. But here we are. Life is like that. Surprises happen when we least expect them. That’s why it’s a financial imperative to have a completely funded emergency fund.
Why have an emergency fund?
Medical emergencies can happen at any moment and you may have to pay significant deductibles before your insurance will cover your emergency. You could lose your job due to economic contraction or corporate downsizing. Until you find a new job, you’ll have to find a way to cover the essentials. You could suffer a long-term physical ailment and need cash to cover your expenses until your long-term disability insurance elimination period is complete. Vehicles break, hot water heaters break, furnaces break, and they don’t ask you to check your bank account balance before they do it. You need an emergency fund.
How much do I need?
Financial experts agree that 3 to 6 months of expenses is an appropriate emergency fund cash reserve. You don’t need 3 to 6 months of income saved. You simply need enough to cover your necessary monthly expenses for 3 to 6 months. Typically, some of your monthly income goes to retirement, extra savings, entertainment, vacations, or other discretionary spending. If you and your family are having a financial emergency, you can push pause on saving and discretionary spending in order to make it through your emergency financially stable.
Whether you should save 3 months of expenses, 6 months of expenses, or something in-between depends on your family situation and your career. If you are single, single with kids, or married with only one spouse working, aim toward covering 6 months of expenses. If your family experiences a job loss it will be devastating if you only have one source of income. If you and your spouse both work and one or both of you are self-employed, consider going more conservative. Self-employment has it’s benefits, but it can have dry periods of low to no income. You’ll need the extra cash if you experience a financial emergency during a dry period. If you are married and both spouses work (especially at different companies), you have the freedom to be less conservative because you will be able to cover most emergencies with only 3 months of expenses saved.
How do I save that much money?
You might be convinced that you need an emergency fund, but you might also be at a loss as to how to save up to 6 months of expenses. It’s a lot of money.
First, you need a budget. You won’t even know how much you need to save in the first place, without a budget. You also won’t know how much, if anything, you’ve saved at the end of the month without using your budget to track what you did spend.
Second, cancel the extras! Since you’ve kept track of your expenses with your budget, you may realize that you’re paying for things you don’t need or want. You might have Netflix, Hulu, Comcast, and Disney+, but only watch one and wouldn’t miss any of the others. You might be paying for newspaper, magazine, online shopping, or other subscription services that you don’t use or barely use. You might have an unlimited data plan, but only use 2 GB a month. If you have stuff lying around that you haven’t used or will never use again – sell it! You can find a lot of quick cash simply by canceling the extras.
Finally, save any extra income. Most individuals receive some extra income throughout the year and it often ends up being spent on entertainment. You might get cash gifts at birthdays or holidays. You might get a bonus. You might have other cash windfalls like a tax refund, winnings, or an inheritance. Any income that’s out of the ordinary needs to go to your emergency fund until it’s fully funded.
Where do I put my emergency fund?
When your emergency fund is finally fully funded (and while you’re building your emergency fund), you have to park the cash somewhere. The best place stash your cash would be in a high-yield savings account (not a CD) or a money market account. There are a few reasons for this suggestion. First, you want your emergency fund to be there when you need it. A savings account is backed by the FDIC and won’t reduce in value. A money market account is designed to never go below a dollar per share, so it won’t reduce in value. With either option you don’t have to worry about volatility. Second, you’ll get better rates with a high-yield emergency fund or money market account than you would in a checking account or regular savings account. Third, it usually takes a few business days to move money from a high-yield savings account or money market account to your checking account. You’ll be less likely to dip into your emergency fund for non-emergency expenses if access to the funds is delayed by a few days.
What about using a credit card for emergencies?
You may be asking yourself, why go through the trouble of saving all this cash and just let it sit there for a “rainy day” when instead, I could use my credit card as my emergency fund and spend the money I’ve saved on my family or myself? Listen, a credit card can be used in an emergency to make the payment to the hospital or the electrician, etc., but you’ll have to pay off that credit card bill somehow. If you don’t pay off the credit card bill in-full before it comes due, you will rack up interest charges, leaving you with a new financial emergency. Shuffling the balance from one credit card to another isn’t a long-term solution either. You have to pay the bill sometime. Think about how comfortable you’ll feel knowing you have the cash now to cover any bill you might have in the future. You wont’ have to scramble to make enough money by the time the bill comes due.
Emergencies happen. They are always a surprise. The question isn’t if they will happen, it’s a question of when they will happen. A fully funded emergency fund can give you the financial safety net you need.
Remember, you can become financially confident and you can have a better investment experience.