By Holger Reinel | Updated on May 22, 2020
An emergency fund is an amount of money set aside to cover unexpected expenses such as an urgent car repair, home repairs, a medical emergency, or losing your job. It is a buffer that gives you peace of mind to know that if something awful happens, you have money to deal with it, instead of taking out a loan or facing financial hardship.
Stuff happens, cars break down, the ac goes out of commission, or you lose your job and need to pay rent quickly. Wouldn’t it be great to have a safety net? That’s what an emergency fund is for; it will save you from financial ruin.
Let’s take a look at what an emergency fund is not:
The purpose of an emergency fund is to have a financial safety net that allows you to pay for emergency expenses should the need arise; yet, according to a 2019 study 40% of Americans don’t have enough cash to pay for an unexpected expense of $400. More and more people are relying on debt.
The issue is people do this in reverse. When a crisis comes, they get in debt, and then, they spend years paying back the debt plus interest. With a “rainy day” fund, you’re paying yourself first; when and if a crisis comes, you’ll have the financial means to get through the difficult time, and you won’t be stuck paying credit card bills forever.
Know this, if you do not have an emergency fund, it is an emergency that you set up one, even if this means cutting back on expenses for a while. I don’t exaggerate when I say that this can save you from financial ruin.
Once you have some money stashed away, don’t spend it; forget about it for a while. In times of need, you’ll be glad to have the extra cash.
Make sure you can distinguish between emergency money from everything else. Some banks allow you to label sub-accounts according to your saving goals. By labeling your emergency account as such means you won’t mix spending money with the emergency fund. However, make sure you’re not paying duplicate monthly bank fees.
For some nifty ideas how to save money check out our Saving Budget Calculator.
For families where both partners earn income, the best way to save money is by adjusting your spending to depend on one income, while using the second income for sayings, including emergency funds, sinking funds, travel funds, etc.
All that it takes is discipline.
When my wife and I got married, we made the decision I would pay for all expenses in the house while my wife’s income went into joint savings accounts, one of which was an emergency fund. I must admit, the one area where we did indulge was travel, so we had a separate travel fund.
Using this method prevents you from living beyond your means. You learn to live on one income while using the second income for savings, and fun. It works!
You should save enough to cover 1 – 6 months of your income. For families with two incomes, three months of income is sufficient, but for single-income households, you want to have savings of at least six months’ worth of expenses.
The Bureau of Labor Statistics reports that the average time to find a new job is about 17 weeks. That’s roughly four months, but due to the coronavirus pandemic, people might find themselves unemployed for even longer.
If your monthly expenses total $4,000 per month, that means you need anywhere from $4,000 (one month) to $24,000 (six months) as an emergency fund. However, the important part is to save money for unexpected expenses, even if that means saving $1,000 or $500.
Start small and build from there.
For higher earners, if you suddenly lose your job, unemployment benefits may not be enough to sustain you. You don’t want to be at the mercy of the government because that won’t be enough to save you from experiencing financial hardship.
When a financial emergency arises, you need quick access to funds. This means for most people, the best place to keep emergency money is in a savings account. Using emergency money to buy stocks or bonds wouldn’t be wise because you could lose it, especially during a crisis.
Also, let’s not forget about inflation. Saving accounts typically pay under 2% interest, even high-interest accounts; that’s not enough to keep up with inflation.
Another good option of where to keep your rainy-day fund is using short-term term deposits, CDs, or GICs where you get a guaranteed interest rate. If you need to withdraw the money before the term is up, you forfeit the interest, but the principal is kept safe from market volatility.
When it comes to emergency money, safety trumps risk, so choose an account where you know the money will be there for when you need it most.