What is an emergency fund?
Financial security is the ability to withstand times of hardship or misfortune that may result in unexpected expenses. Having an emergency fund is the key to being able to pay for events like these and still cover your regular monthly payments.
An emergency fund is a savings fund that is set aside for life's little and big scenarios that require extra money beyond your normal flow of income. Maybe you have to cover an insurance deductible for home damage or get unemployed. Unexpected life events like this lead to emergency needs the most, and these are the exact ones we cannot plan.
When should you start an emergency fund?
An emergency fund should be planned for and started right away. If you are younger, it may seem daunting, but your emergency fund needs will be smaller. If you don't have an emergency fund set up, do not panic. But now is the time to create a plan and focus on implementing one.
How much money should you have in your emergency fund?
How much to save is a question people ask all the time. After all, how do you plan for the unexpected? Many see the importance of protecting against an emergency but get stumped when trying to set a dollar amount to target. The answer is it varies depending on everyone's needs and financial obligations.
Here are a couple of guidelines to follow. If you are younger and just getting starting, then having $1,000 set aside is recommended. If perhaps you are a bit older with more obligations, having 3-6 months of expenses set aside will be preferred. Once $1,000 is reached, then stretch your next goal to $2,000. After $2,000, extend your emergency fund to $3,000, and keep increasing the fund this way.
Where should I put this emergency fund?
Perhaps as important as setting up an emergency fund, is where you store it. Many make the mistake of building up their checking account that they use day to day with emergency funds, but this allows for easy access to those funds for non-emergencies. Some people will store the money at home, in a safe or their secret hiding spot. This too is a poor strategy. Your home may catch fire, suffer flood damage, or you may be more tempted to use that cash since it is very easily accessible.
The preferred places for your emergency fund are separate accounts from your main everyday account. Savings accounts are the most ideal since they provide access should you need your funds quickly. Higher yielding savings accounts, such as money market savings, are a great option. They provide you with higher interest than typical checking or savings account. This interest will help grow the account over time. Typically with savings accounts, you don't get a debit card or checks, which means you may be less tempted to touch the money for a non-emergency.
What are appropriate uses for an emergency fund?
Now that we have a fund set up in a separate savings account, when should we use it? This question may vary for many, but technically, an emergency is when it is unexpected, necessary, and urgent. Keep in mind that birthdays, everyday bills, and other personal reasons are not emergencies. A broken-down car, a new roof, or severe medical bills that can't be deferred, are all excellent examples. These are the types of situations that require you to utilize your emergency fund.
How to build an emergency fund
Thinking about doing something is one thing, but doing it is what matters most. Let's discuss a few pointers and ideas about creating your very own emergency fund. With all these tips, keep in mind that there will be a level of sacrifice involved. Otherwise, nothing changes.
First and foremost, you need to make a budget. Before you can create a budget, you need to list out all your income and expenses. From there, you can decide the expenditures that really “need.” Anything beyond that can be allocated to savings.
A good rule of thumb is that you will want to have at least 20% go to savings. If you cannot do that right away, do not get discouraged. Having it as a goal will give you something to aim for.
After having a budget and savings goal, next, you can cut down on expenses. Take a look at all your monthly payments and see where you can make cuts. Do you have a gym membership you don't use? Perhaps any online memberships you don't use or need. Minimize your bills by making changes to the service or products you receive.
Next, you can also take on any potential side hustles. A side hustle is simply something you do outside of your 9-5 to make extra money. Some examples might include; driving rideshare, freelancing some skill you have, doing landscaping or any other service-based local service.
Another popular way is to sell many items in your home that you no longer use. List them all on eBay and other local sites and make some extra money. Just be sure to put all your earnings into your new emergency fund savings.
Should an emergency fund come before paying down debt?
There are different trains of thought on how prudent it is to save money in an emergency fund when you have higher interest debt to pay off. The idea is that your emergency fund is likely only making 1% to 2%, while you may be paying 10% or more in interest on your loans.
However, if an emergency does arise, you do not want to be caught without having and cash. Not having any means that you will likely have to turn to your credit cards, which could result in even more high-interest debt.
The bottom line, is you need to find a happy medium where you can do both. Everyone's situation is different; however, it is a good idea to have at least one to two thousand dollars saved in an emergency fund. Once you have a safety net, you can tackle your credit card debt, school loans, etc. Basically everything other than your mortgage.
Once you have your loans/credit card debt paid off, come back and build that emergency fund so that you can cover three to six months of expenses should you lose your job.
Now that you have all the information that you need, it's time to start building your emergency fund. Having this account set up is the foundation of building other wealth; retirement accounts and real estate, as examples. Also, having an established emergency fund gives you peace of mind and satisfaction of knowing that if some curveballs in life come your way, you are ready!