An emergency fund is your financial body armor against the gut punches in life.
Like discovering an ugly water stain on the ceiling, which is now slowly spreading down the wall.
Or when your dog slips on ice and falls back down every time she tries to stand because she can’t move her back leg.
Or when you press the “on” button for your dishwasher, and it stares back at you, dully, ignoring your request for clean dishes.
An emergency fund is there to help you with those unexpected yet inevitable expenses.
It provides immense peace of mind in your financial life.
Let’s discuss this vital financial fund.
What Exactly Is An Emergency Fund?
An emergency fund is your protection against the unexpected expenses you can’t plan for—essential items with a price tag due immediately. You can’t always save up for them because you don’t see them coming. The only guarantee is they will happen.
This money is for financial emergencies, not things like “sale opportunities” or things you want to buy. Those are a different category because you can plan for them. For example, redoing a bathroom is not a financial emergency. But the leaking pipe dumping water in the bathroom is an emergency.
A litmus test for whether or not something is a financial emergency is to ask if spending the money is painful or fun. Most financial emergencies aren’t fun.
Why Do You Need An Emergency Fund?
An emergency fund gives you financial confidence, knowing you have a safety net.
After all, the reason you need emergency fund money is probably stressful enough already. You don’t want to add financial stress to the mix!
Here are some examples:
- Medical expenses that cost you out-of-pocket, like ER visits (especially if you have a high-deductible health care plan).
- Dental expenses such as old fillings failing or breaking a tooth (ouch!).
- Vet emergency expenses for your furry loved ones. One wintry day, my dog enthusiastically jumped off the steps onto an icy patio. Her back leg slid out, and she cried in pain. She couldn’t move her back leg, so off to the vet we went. The good news is our emergency fund covered that expense, AND she ended up healing without an issue. But we were thankful we had the funds.
- Home repair expenses like needing to replace your roof. Many times, delaying home repairs leads to even more expensive issues later.
- Home-appliance expenses when you need to replace ones that stop working. Maybe it’s just me, but does anyone enjoy shopping for a dishwasher?
- Vehicle expenses related to unexpected repairs or accidents. Even with insurance, you’ll need to come up with the deductible.
And the biggest and most unpleasant of all—a hit to income.
Income reductions, like when you’re told you get to keep your job, however, your hours will be cut or your salary reduced. Or being told there will be a sharp reduction in available overtime (for hourly employees).
Or the ultimate financial loss of unemployment.
Life has risks, and we underestimate them in the short term. As Morgan Housel states:
“…Save heavily, knowing with certainty that you’ll need a cushion to deal with the next banana peel. Be a little bit paranoid, knowing the assumptions you hold today could break tomorrow, and you’ll need enough room for error to make it to the next round.”
Besides the emotional relief emergency funds provide, they also help you avoid debt. Instead of using high-interest debt like a credit card or a personal loan, you can borrow from yourself.
You could use a credit card to pay the expense with the comforting thought that you have the cash to pay off your bill the next month.
Having an emergency fund helps you save money on both interest and fees.
Having a pool of funds also can avoid a hardship withdrawal from retirement accounts. Hardship withdrawals will set you back in your FI journey because once you withdraw that money from your account, it cannot be repaid! You’ll owe taxes on it, and it’s removed from your tax-advantaged retirement account forever.
When Will You Know You Have Enough Saved In Your Emergency Fund?
It depends on what your current expense level is, aka your lifestyle. It also depends on how risk-averse you are.
If you have nothing saved right now, start small. Aim for $100. A lot of financial sites recommend $1,000, and that’s great if you can. But don’t get discouraged by aiming too high to start.
Many times, getting started is the hardest part.
A rule of thumb is to save 3 to 6 months of living expenses. How do you know how much that is? Your budget. You do have one, right?
So, if your living expenses are $40,000 a year, you’d want to save $10,000 to $20,000. Rules of thumb are great for getting a general idea, but everyone’s situation is unique.
If that number is too intimidating, think in terms of saving in stages.
In the first stage, have at least something to cover the financial bumps in life. Here your goal could be aiming towards the $1,000 mark.
For the second stage, save up an amount that covers your basic necessities—an emergency budget. Have money to pay your monthly bills and to buy food, gas, and other essentials. This will cut the amount you need to save considerably.
You may feel comfortable stopping here. Plus, with interest rates at all-time lows, you may not want more money than this in cash or cash equivalents.
(Remember, I‘m not a financial adviser, and this is only meant to be informational. It’s up to you to make your own decisions, or speak with a financial professional if you need one.)
The third stage is having enough for the basics plus some comforts. How much money this would require depends on your lifestyle. It could include money for some entertainment, new clothes, eating out, etc.
So now that we know how much per month you want to save, the next question is, how many months of savings do you need?
This depends on your income sources.
Here are some questions to help you decide:
- How many different sources of income do you have? Two-income households may need lower savings than a one-income household. Note: this is why having multiple income sources is an excellent strategy, and income-producing side projects are a fantastic idea.
- How stable are your income sources? What are the risks in your industry or line of work?
- How variable is your income? Do you earn have commission-only earnings? Do you rely on overtime (if hourly)?
- How tough would it be to get another job doing your work (if you’re an employee)?
- How long have you been employed with the same company? For some, this is an asset because your company values your experience. However, for those of us who are older, ageism is an ugly reality. The longer you’ve been with a company, the more you earn, and the more likely you are to be laid off in the next downturn.
- How well-established are you in your field if you‘re self-employed? How much experience do you have? Do you have multiple clients? Multiple products?
Based on your answers, you can determine how many months of savings you’ll need to feel safe. This is entirely subjective, again depending both on your situation and your aversion to risk.
Now that you have a goal to aim for, the next step is to build it!
How Do You Build Your Emergency Fund?
The first step to building your emergency fund is to add it as a savings goal into your budget.
Add it in as a priority, near the top of the list. Pay yourself first and make it automatic.
If you’re employed, have your employer split a portion of your check and move it to a savings account.
Or move money from your checking account to your savings account using an automatic transfer. The mechanics of this will depend on your bank, but generally, this requires you to link the two accounts (checking and savings, or two savings accounts) and then set up an automatic transfer.
Again, you’ll want a separate account, hidden from yourself.
Some other ways to bump up your savings are to look around your living space. Is there anything you don’t need or use that you could sell?
When unexpected money comes into your life, consider adding a portion to your emergency fund.
You build your emergency fund one month at a time, and by adding to it every opportunity you get. Each dollar you add brings you that much closer to your goal.
Where Should You Stash Your Emergency Fund?
This money needs to be kept in a safe place, ideally at an FDIC or NCUA insured bank or credit union. This gives you $250,000 of protection if the institution fails.
You want an account separate from your checking account or other savings accounts. Keep it where you don’t see the balance. Hide it from yourself to reduce the temptation to use it for non-emergencies.
It needs to be liquid, which means you could get access to your money quickly and easily. For that reason, this money should be in cash or cash equivalents. An online savings account or a money market account are ideal.
You could consider a no-penalty CD if it had higher interest rates (although right now they don’t). A no-penalty CD means you can withdraw your money without a penalty, even before the maturity date. With other types of CDs, you’ll pay a penalty in lost interest if you withdraw the money early.
However, this may not be the best option in a real emergency because of potential delays in gaining access to your money.
Right now, interest rates are pathetically low, but the purpose of an emergency fund isn’t to earn money. Instead, it’s there to protect you. I know, technically, you’ll lose money due to inflation, so there could be a small cost to emergency funds.
But the psychological benefits far outweigh the small costs, and crazy-low interest rates shouldn’t last forever.
Now Go Forge Your Financial Body Armor
An emergency fund is essential because, well, life happens.
Having money for financial emergencies in life can help soften the blows. Yes, it still hurts, but it hurts a whole lot less.
So when you look at the water stain on the ceiling, you know you can afford to fix the roof.
You know you can afford to bring the dog to the vet.
And you can buy a new dishwasher, even though it’s one of the last things you want to buy.
Get started now. Wherever you are in your financial journey, start with this building block.
And the first time you need your emergency fund, your future self will look back with gratitude!