Preparedness plays a huge role in ensuring financial stability. You don’t need to “expect the unexpected”, but you can be ready for it!
There are many techniques that you can use to be prepared in case of an emergency or significant financial decision. These things can include account and investment diversification, financial goal setting, and building an effective budget, among other things.
One of the most crucial pieces of your financial preparedness is starting an emergency fund.
What is an Emergency Fund and Do I Need One?
An emergency fund is an amount of money that you have set aside for use in the event of a financial emergency or unplanned expenses.
The purpose of building one is to have funds to fall back on in the case of financial struggles such as job loss, unanticipated medical expenses, major home or car repairs/replacement, or caring for a loved one in a time of need.
National or global events that lead to financial hardship can also be a cause to prepare for with an emergency fund. Unemployment and resource scarcity due to the coronavirus pandemic in early 2020 is a great example of where an emergency fund can be extremely helpful.
We highly recommend that if you don’t have an emergency fund set aside already that you start planning for one now.
How Much Emergency Fund Should I Have?
The general rule of thumb is that your emergency fund should cover 3 to 6 months of your expenses. Depending on the emergency you’ll likely look to cut expenses, of course. But for the sake of preparing, anticipate that your recurring expenses will stay as is, and have all current expenses covered.
Calculating your living expenses will give you the goal for which you’ll want to save. Then, you can build this into your budget and savings habits.
Step by Step: How to Save For an Emergency Fund
1. Organize and Calculate Your Expenses
Organize your recurring expenses by looking through credit or debit transactions, bank statements, or referencing your budget. Calculate your total monthly expenses to use for setting a goal balance in your emergency fund.
Knowing your expenses is an essential first step to building an effective emergency fund, being that the goal is to cover your living expenses for a certain period of time, should your income be reduced or go away.
It can be helpful to categorize your expenses and label them by necessity or separating “needs” vs. “wants”. However, we recommend to include all monthly expenses, necessary or not, so that you’re more than covered in the event of an emergency.
2. Set a Timeframe for Having Your Emergency Fund
Choose a month or date that you want to have your emergency fund filled. Of course, we recommend making this happen sooner rather than later because you can’t anticipate most financial emergencies. However, it’s important that you work this comfortably into your budget and money habits.
Setting a timeframe for your emergency fund will help you set incremental monthly savings goals and stick to your plan. It will also make working this account into your existing savings methods much easier.
3. Calculate Your Emergency Fund Goal and Savings Increments
Break down your overall emergency fund balance goal into monthly increments, so you know how much you’ll need to save each month to achieve your goal. Keep in mind you’ll want to have enough for 3 to 6 months’ coverage for all of your expenses.
4. Modify Your Savings Methods
Once you have a monthly savings amount that you feel you can comfortably contribute to your emergency fund, it’s time to work that into your existing savings habits.
Review your current distribution of cash from each paycheck and adjust as needed. If you don’t have a set method for saving and distributing your income, this is a great opportunity to learn more about establishing healthy saving habits.
5. Monitor and Adapt Your Saving
As with all accounts, you should keep an eye on this over time and adjust as needed to fit your lifestyle and income.
You may need to dial back your contributions to emergency funds if you have achieved your coverage goal. Or, you may need to increase your contributions if you’ve taken on new expenses.
We recommend contributing small amounts regularly even if you’ve already achieved your monthly coverage goal. This can be very simple with the use of direct deposits as a secondary account.
Where To Keep Emergency Money
There aren’t typically exclusive “emergency fund” accounts available from financial institutions, but you can use any type of savings account with easy access to funds for this purpose.
We recommend opening a savings account of some sort for this purpose rather than stashing cash. Savings accounts are FDIC insured up to $250,000 and have the ability to earn interest, so there isn’t risk of losing this money and you can make a little extra while the account is open.
Emergency Funds and Investing
We recommend securing a comfortable emergency fund with a bank or credit union separate from and prior to venturing too far into investing if you haven’t already. The risk and volatility of investment accounts does not align with the purpose of emergency funds.
For instance, what if a financial emergency arises in the midst of a particularly low time for your investment portfolio? You don’t want to be forced to withdraw funds at a loss to cover expenses.
This is a great example of why having a separate emergency fund can be beneficial. Using that money will allow your investments to wait out the declines and have a chance to rebound.
When is it Okay to Use Emergency Funds?
Defining “emergency” and setting rules for yourself for valid uses of emergency savings is an important part of planning your emergency fund. Keep in mind the purpose of emergency funds – to mitigate financial hardship and cover expenses in the case of unplanned events such as job loss or significant unexpected repairs.
With that being said, using your emergency funds to take on new expenses such as a down payment for a home or car is not wise.
As you’re setting up your emergency fund account, take the time to set some ground rules for yourself and stick to them. Using emergency money for spending only increases your risk of needing it, and then it won’t be there.