Building an Emergency Fund for Peace of Mind
- April 5, 2021
- by Angela
Have you ever had a sudden expense that you did not expect? The question is not if but when. The next question is, how can you pay for a sudden expense? That is the purpose of an emergency fund: to make sure you can focus on the problem at hand and not end up with a financial emergency on top of a life emergency.
So, what is an emergency fund and what isn't an emergency fund? Why should you have an emergency fund? How big should it be? Where to keep your emergency fund? Read on to get answers to these and similar questions.
What is an emergency fund?
An emergency fund is a bank account with ‘safe’ money set aside to pay large sudden expenses such as:
- Unforeseen medical expenses
- Death in the family (travel, burial fees, etc)
- Sick pet
- Major auto repair
- Leaky roof
- Plumbing issue
- Home appliance repair
- Unemployment - if you suddenly lose your job you can continue to pay monthly expenses
More later on what ‘safe’ money counts as.
Why is it good to have an emergency fund?
- Keeps your credit intact - if you have debts such as credit card, auto, or mortgage, in the event of an emergency where your income is reduced you can keep making regular payments. This keeps your credit score from falling and lets you avoid late payment fees and other penalties such as a higher interest rate if you miss payments.
- Keeps your lights on - if you miss payments to your utility company you run the risk of being without electricity, water, or heating.
- Keeps your car running - you may need your car to get to your job, so it makes sense to keep it in working order.
- You’ve just started budgeting - sometimes you happen to omit some expenses you had to pay. Your emergency fund will help smooth out any variances as you get used to budgeting.
- Your household has only one income earner - if the income earner loses their job or stops working due to illness, your emergency fund will take care of housing, food, utilities, etc. This is also true for single parents. For people in this situation you might consider an emergency fund that lasts longer vs a single person without kids, or a couple with two income earners.
- You are self-employed or are a freelancer - in this case your income may fluctuate more than a person with a regular “day job”. Consider if your industry is seasonal or you are just starting out and pad your emergency fund accordingly.
- You own your home - they say you don’t know the “joys of home ownership” until you get hit with your first huge repair bill on your house. Owning a home, in particular an older one, will incur many repair bills you don’t expect. So having a larger emergency fund to cover these expenses is good planning ahead.
- You live away from your family - in which case the costs are high if you buy a plane ticket at the last minute to visit during an emergency.
- You have medical problems - if you know you need surgery or have a chronic condition that could flare up, having money set aside is a good idea.
- Save for the goal - if you want to buy a new house or car or want to open your own business, you need to have an emergency fund, because it will significantly help you achieve the goals you want and give you flexibility on the way.
Where should I keep my emergency fund?
An emergency fund is usually placed in a savings account. Keeping it in a bank, where it earns a bit of interest is much safer than keeping it under your mattress. All bank and credit union accounts in the US are required to be FDIC / NCUA insured. That means if the bank collapses the federal government will ensure you don’t lose anything. This applies to any balance below $250,000. For most people that limit isn’t an issue.
There are a few types of savings accounts: money market, high yield, and certificate of deposit (CDs). Any of these would work fine, though the interest rate may vary. Shop around to get the best deal. For more on savings accounts see our post that breaks down different types of savings accounts and discusses the insurance on them. Having a dedicated account for your emergency fund will help you avoid spending it on an impulse purchase. CDs have to be ‘broken’ to access the funds which usually involves a call to the bank or credit union.
In any case with a savings account that has substantial funds, you may want to consider turning off overdraft protection to protect the balance.
What isn't an emergency fund?
A checking account is NOT a good place to keep an emergency fund because it can more easily be spent, especially if it is tied to a debit card.
You may own assets such as precious metals, stocks, cryptocurrencies, etc. They should not count towards an emergency fund because their value fluctuates up and down. Perhaps the emergency you are experiencing, such as a job loss, goes hand and hand with a recession, which has caused the stock market to drop too... These assets may also be kept inside tax deferred retirement accounts which carry withdrawal penalties and more risk than a regular savings account.
Other assets you may own and have equity in such as your car or home are also not included. That is because of the time and hassle it would take to convert the asset into cash. Only ‘liquid’ assets that are readily available as cash count as an emergency fund (with some minor exceptions).
A credit card isn't your emergency fund because:
- This is borrowed money - when you save your money in the bank, you give it your "future self". On the other hand, when you borrow money on a card, you go into the red and you need to return the money you borrowed from the card using future income which may not be as easy as before.
- The interest rate is high - paying for an emergency with a credit card not only creates debt, but you will pay interest on that debt! Most credit cards charge double-digit interest rates, making it even harder to get past.
- A credit card may not be accepted - the bill may be so large it will not fit within your available credit. Some providers (funeral homes, plumbers, etc) will not accept credit cards and require a check.
The only exceptions to a savings account worth mentioning that make possible substitutes for an emergency fund are:
- A HELCO (home equity line of credit). These generally have pretty decent interest rates. While it is not ideal to borrow against your future self in an emergency, a HELOC can be a possible stop gap while you are building up an emergency fund.
- Some retirement accounts such as Roth IRAs and 457 plans allow withdrawals before retirement age. If these funds hold low risk assets that won’t drop during a stock market crash (such as cash equivalents, treasury bonds, etc) then in theory that portion of the account could be counted towards your emergency fund. However making the withdrawal is complex. If you do it wrong it could trigger penalties and increase your taxes. Talk to your accountant and financial advisor first.
How to build an emergency fund?
- Calculate the amount you want to save and budget for it - Wealth Meta has a calculator for that!
- Set a monthly savings goal - the easiest way to do this is to automatically transfer funds to the emergency savings amount as soon as you receive your paycheck.
- Keep the change - if you have left over coins or small bills, collect them in a jar and every so often take it to the bank and put it in your savings account.
- Save your tax refund - if you get a refund when you pay your taxes, you can redirect that money to your savings account for the emergency fund.
- Estimate and adjust contributions - if you've raised enough money for emergencies within six months or even raised twice as much, then you can open another savings account for vacations, debt reduction, or for having fun.
How big should your emergency fund be?
Many experts believe that an emergency fund should last three to six months but some people have two or three years of emergency funds set aside. It is a personal decision and depends on several factors.
A three month fund makes sense if:
- you are in good health
- you aren’t over-indebted
- you live in an area where the cost of living is low
- you have your own (or rented) car that is reliable
- you can easily find a new job if you lose the previous one
- you do not have a family or pets to take care of
- you have a partner or family you can rely on in case you need financial help
A six month fund would make more sense if:
- you live in an area with a high cost of living
- your job skills are more niche making it difficult to find a new job if you lose yours
- you own your own home (especially if it is an older place)
- you work as a seasonal worker, freelancer or you are an artist
- you have a health condition or are doing a risky job
- you do not have a financial support network
A year long fund is ideal in the following cases:
- you have a high monthly salary (and expenses)
- you have a spouse who is not working, children, pets, and other family members that you support
- you work in a position that requires frequent relocations
- you are the only income earner of several dependent persons
- you are nearing retirement
According to the above, it is best for the emergency fund to be built for three to four months by people living in smaller cities, singles who have no family or pets, and who can easily find a new job if they suddenly lose their previous job.
The emergency fund for up to six months is built by people who find it harder to find a job when they lose their previous ones or if they work seasonal jobs or as freelancers because they need to have savings until they find a new job.
An emergency fund for up to a year is good for people with high incomes and expenses. This fund size is also better for people who have families where only one family member works.
If you want to live without stress, to always have a calm mind, the best solution for unexpected expenses is an emergency fund. Check out our Emergency Fund Calculator to analyze your own situation.