An emergency fund is a bank account with money set aside for large, unplanned expenses. If you are unaware of the importance of an emergency fund account, you are among many others. In this blog, we have explained what is an emergency fund, how to start saving for it, and how much should an emergency fund be.
Unexpected emergencies are inevitable and can arise in any form. From unexpected medical emergencies to automobile failure, we have all experienced them in some form or another. People who have experienced significant and unforeseen experiences will often tell you how important it is to create and build an emergency fund.
Like most finance-related issues, preplanning is one of the key factors to face and recuperate from emergencies that are inevitable in life. Setting up a dedicated savings account or emergency fund is one of the best ways to protect yourself from these challenges and also save a substantial amount. By putting a certain sum aside for unplanned expenses, you can tackle these unexpected challenges and get back faster to achieve your financial goals.
Let’s dive in.
- What is an Emergency Fund?
- Why Do I Need an Emergency Fund?
- How Much Should An Emergency Fund Be?
- Where Can I Invest My Emergency Funds?
- How To Build an Emergency Fund?
- Expert Tips to Help You Maintain Your Emergency Fund
- Benefits of Having an Emergency Fund Account
- Final Words
- Frequently Asked Questions(FAQs)
What is an Emergency Fund?
An emergency fund is typically a cash reserve or money set aside dedicated to large, unexpected expenses or financial emergencies. Emergencies can be in various forms including medical bills, loss of income, car repairs, home repairs, etc. The purpose of an emergency fund is to be a safety net that you can comfortably fall back on in case of such emergencies. The money will allow you to sustain your lifestyle for a few months if something unexpected comes up without incurring any debt.
It acts just like an insurance policy but instead of paying premiums to a company, you are paying yourself money and saving it for use at a later date. Moreover, unlike insurance claims, emergency funds can be accessed easily and instantly in case an unfortunate event occurs.
Why Do I Need an Emergency Fund?
Without substantial savings, even a minor financial setback can be disastrous and may result in debt. An emergency fund creates a financial buffer that can help you sustain yourself without relying on loans or credit cards that often have very high interest rates. Moreover, if you already have debt, it is debt to set up an emergency fund as it will help you avoid borrowing more money from lenders.
According to research, individuals who struggle to recover from financial shocks often have little to no savings to protect themselves. They often rely on loans, credit cards, or other sources to acquire money and also destroy their other savings like retirement funds to cover their expenses.
How Much Should An Emergency Fund Be?
The amount of emergency funds you require primarily depends on your financial condition. Recall the most common kind of unexpected expenses you had in the past and how much they cost. This will help you set a goal for yourself and start saving right away.
However, if you are surviving from paycheck to paycheck or don’t have a fixed paycheck, it can be difficult to start saving money. But it is important to remember that even a small amount can make all the difference in emergencies.
However, as a rule of thumb, an emergency fund should at least have three to six months of your income, depending on your expenses and income. If you are earning $1000 per month, you should have at least $2500 to $3500 in your emergency fund.
You can also divide your emergency funds into 2 categories- long-term emergency funds and short-term emergency funds.
Long-term Emergency Funds
This emergency fund account should be set aside for larger expenses like medical emergencies or natural disasters. You should try and invest the funds in an instrument that provides slightly higher interest rates, even if it takes a couple of days to liquidate.
Short-term Emergency Funds
This is your primary emergency fund that you will use in case of emergencies. You can choose any instrument that offers little interest but is immediately accessible. In extreme financial situations, make sure even your short-term emergency fund can sustain you until you get access to your long-term emergency funds.
Where Can I Invest My Emergency Funds?
Typically, you can use a savings account with high-interest rates and quick access to invest your emergency funds. It is important to have quick access as emergencies can happen at any time and place. Avoid long-term investment plans and make sure the account is separate from the bank account you use daily to avoid burning through your savings.
One of the best options is a high-yield savings account. It is federally insured up to $250,000 per depositor, per ownership category, and per financial institution, making it a safe and trusted choice. Moreover, it also offers high interest rates and the money can be quickly accessed in case of an emergency, through withdrawal or bank transfer.
While a savings account is the best option, some people may struggle to open one immediately. If for some reason, the bank closed your previous account, it can prevent you from opening an account in a new bank. If this is the case, you can either submit your query and resolve the matter with the bank or you can also consider opening a second chance checking account.
Here are a few other options to put your emergency savings-
Bank or Credit Union Account
It is widely regarded as one of the safest places to put your emergency savings. If you have an account with a bank or crest union, you can use it as an emergency fund account. However, it is important to make a dedicated account where you can safely store and maintain your money.
As the name suggests, a prepaid card allows you to load money to use at a later time. It is not affiliated with any bank or credit union and you can only use the funds available on your card. While this is not the safest option, it does give you instant access to your money in case of an emergency.
Another popular option is keeping hard cash at hand for emergencies. You can safely store it at your home or with a trusted family member. However, one major drawback is that cash can be stolen, lost, or destroyed, so proceed with caution.
How To Build an Emergency Fund?
Building the emergency fund will be easier if you are in the habit of saving money. However, if you are new to savings and want to start fresh, here are some principles to keep in mind-
Calculate the amount you want to save: Depending on your income and expenses, you can calculate how much you want in your emergency fund. As a rule of thumb, an emergency fund should have at least 3 to 6 months of your monthly income.
Set a monthly Savings goal: Instead of focusing on an intimidating larger goal that might seem impossible, focus on smaller monthly savings goals to get you started. Regularly achieving your monthly milestones can motivate you and provide you with much-needed momentum, to encourage you to keep saving.
Transfer money into your savings account immediately: If your employer offers direct deposit, you can ask them to split your paycheck between checking and savings accounts. This way you can achieve your monthly savings goal without the issue of burning through your savings.
Use dedicated savings applications: There are multiple mobile applications that can help you save that link with your checking accounts. These apps round off the purchase amount of your transactions and transfer the extra amount directly to your savings account.
Save your tax returns: If are expecting a refund, you can use it to increase your savings once a year. It can be an easy and reliable way to boost your emergency savings. When you file your tax returns, ensure that they are directly deposited to your emergency fund account. You can also consider adjusting your W-4 form so you will have less withheld money.
Assess and adjust contributions: Check in after a few months to determine how much you have saved and make adjustments if needed. When you have saved enough to cover at least six months of your expenses, you can use the extra cash for investments.
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Expert Tips to Help You Maintain Your Emergency Fund
If you are new to saving money, there are various strategies that can help you get started. These strategies are tailor-made and cover a range of situations. Even if your pay fluctuates or you have limited ability to save, these strategies can be useful for you.
Manage Your Cash Flow
The cash flow can be defined as the timing of when your money comes in(your income) and going out(expenses and spending). If the timing fluctuates, you will often find yourself running short at the end of the month. If you are actively tracking your cash flow, you will soon find opportunities to adjust your spending and savings.
For instance, you can ask your creditors like landlords, utility bills, and credit card companies to adjust the due date of your bills. If you are left with any extra money, you can add a little extra to your savings.
This strategy is helpful for anyone as tracking your cash flow is the first step to managing your money regardless of whether you are living paycheck to paycheck or have a tendency to spend more.
Take Advantage of One-time Opportunities
There are often certain times during a year when you get a surplus of money. A tax refund is one of the largest cheques an American receives in a year. There are also other examples like holiday money, birthday money, or receiving a cash gift.
While it may be especially tempting to spend this money, saving a portion of all of it can help you build your emergency fund quickly.
This option is best for individuals with fluctuating incomes. If you receive a large cheque from a tax refund, it is best to put it into your savings account as it will compensate for all the months you saved less than usual.
Use Automatic Payments to Save Money
One of the best ways to make your savings consistent is to start saving automatically. You can do this by setting up recurring transfers to move money automatically from your checking account to your savings account. You can also decide how much you want to transfer and how often. Once you have the automatic payment in place, you will be making regular contributions to your savings without any hassle.
However, it is also important to check your balances regularly so you don’t incur overdraft fees. If there is not enough money in your checking account at the time of transfer, it is best to pause the automatic payment or arrange the money from an external source and pay it back once you receive your income. You can also set up calendar reminders and notifications to remind you to check your balances.
This option is especially helpful for individuals with consistent income. You can determine how much and how often you want to save and transfer between accounts, but it is also important to maintain a regular cash flow.
Save Through Work
You can also automatically save money through your employer. While most employers provide contributions for retirement, you also have the option to split your paycheck between your savings and checking account. You can check with your employer to ensure whether it is possible to split your check and divide it between two accounts.
It is one of the best ways to save money without thinking about it. Moreover, you won’t even be tempted to spend more as it will be transferred directly to your savings account.
This option is helpful for individuals with consistent income who receive regular paychecks. Avoid spending more by directly transferring a portion of it to your savings account.
Benefits of Having an Emergency Fund Account
Besides financial stability, there are other additional benefits of having an emergency fund account.
Helps in Avoiding Bad Financial Decisions
If you have an emergency fund in place, you will avoid using bad debt options like loans or credit cards to fund your expenses. These sorts of debts often have hidden charges like higher interest rates and various types of fees and penalties.
Reduces Stress Levels
It should come as no surprise that an unprecedented financial emergency can be incredibly stressful. If you are living without a safety net, you’re constantly on the edge and hoping that you won’t run into a financial crisis. Without any cushion to soften the blow, you are taking risks that can be detrimental to your daily life.
However, if you build and maintain an emergency fund, you can avoid unnecessary stress and be confident in the face of crisis which will allow you to overcome unexpected events without worrying about finances.
Avoids Unnecessary Spending
One of the best ways to build up an emergency fund is to ask your employer to divide your paycheck and split the dividend into your checking and savings accounts. It is best to save the money out of your immediate reach so you are not tempted to spend it on frivolous expenses like impulse purchases.
If you want to be extra cautious, you can put the money in a separate account. This will also help you to effectively track your savings and know how much more you need to save to achieve your financial goals.
Encourages the Habit of Saving
By building and maintaining an emergency fund, you get into a habit of saving and it also reduces the temptation of spending unnecessarily on luxuries like fast food, gadgets, and luxury clothing.
While it can be challenging to abandon your luxury lifestyle and save for an emergency fund, you will be glad you did once an unexpected emergency arises. Having an emergency fund allows you to tackle unexpected financial challenges without jeopardizing your financial well-being. At the end of the day, the only person you can rely on is yourself. Emergencies can arise in all shapes and forms and working towards your financial well-being is just as important as looking after your physical and emotional well-being.
It is important to ensure that you put your emergency savings in a fairly liquid instrument that is available immediately. Savings accounts are the best option as they often provide high interest rates and can be accessed instantly in case of an emergency.
Frequently Asked Questions(FAQs)
Ans. An emergency fund is savings dedicated to handling unexpected expenses like medical emergencies, car repairs, and loss of income. It allows you to properly manage your financial well-being in case of an emergency without burning through your savings.
Ans. The debate about paying off debt vs saving for an emergency fund is never-ending. While there are pros and cons to both, paying off high-interest debt should be a priority since it is a heavy financial burden. However, that doesn’t mean you shouldn’t be saving a certain sum each month. It is a good practice to develop the habit of saving. The best approach is to minimize your expenses and strike a perfect balance of both. You can work your way little by little towards saving while reducing high-interest debts.
Ans. While there is no specific amount and it ultimately depends on your expenses and income, experts suggest that you should have at least three to six months of your income in your savings account.