At a Glance
An emergency fund is a reserve of cash that is saved for unexpected circumstances. Having money set aside as a buffer can help you cover large expenses such as medical bills or home repairs, without relying on credit cards or high-interest loans to cover payments.
This article will cover:
Why you need emergency savings
A recent study found that the most common hardships included significant health issues or having work hours/pay reduced. Most individuals who experienced these financial difficulties had to dig into their savings or borrow money.
What an emergency fund should cover
An emergency fund should be used for large, unanticipated expenses or life events that require a sudden payment of cash, such as:
- Car or home repairs
What an emergency fund shouldn’t cover
An emergency fund shouldn’t be used for any big, planned expenses, such as:
- A home addition
- College tuition payment
How much you should save in an emergency fund
You want to save enough to cover three to six months of your necessary expenses. These expenses can include items like rent, food, utilities, etc. If you don’t have enough of a financial foundation to save at least three months, don’t worry. Starting small to save for emergencies with as little as $10 a week, can really help make a difference over time.
Make sure to consider your lifestyle when deciding your ideal savings amount. Do you own a car or home? How stable is your job? Do you have a partner and/or kids? These all factor into how much money you should put aside.
How to calculate how much money you need
To calculate how much you really need, follow this simple two-step process:
- First, write down all of your necessary monthly expenses. Don’t include anything you could easily forgo if an emergency arose, such as eating out. Examples of items to calculate include tuition payments, insurance, rent or mortgage, and credit card debt.
- Multiply this number by anywhere from 3-6 (for the amount of months you’re saving for), depending on your current financial situation and how much you can put aside.
The best places to store emergency savings
Once you’ve figured out how much you need to put aside, the next decision you need to make is where to store your emergency savings. You’ll want to put your money in an account that is easily accessible and has a high interest rate. Avoid stocks, which can be high-risk, or any type of account which penalizes you for withdrawing early. Make sure that your emergency funds account remains separate from your daily accounts. Two recommended savings account options are high yield savings accounts and money market accounts.
High-yield savings account
High-yield savings accounts generally have no minimum balance requirements, free checking, and the ability to earn a high APY (annual percentage yield) compared with other types of bank accounts. The best rates are often provided by credit unions and online banks. As long as you keep your money in an account that’s NCUA or FDIC insured, your money will be safe up to $250,000.
Money market account
Money market accounts are easily accessible savings accounts with higher interest rates. A money market account allows you to write a limited amount of checks per month, but you can make unlimited withdrawals or deposits by going to the bank in person. Money market accounts often have higher balance requirements than your typical savings account, and sometimes require a larger deposit to open.
What are the best strategies to save for an emergency fund?
Saving up for an emergency fund doesn’t have to feel like an intimidating process. A few techniques, like automatic payments, saving through your employer, and using part of your tax refund can give you a solid savings foundation without feeling like a hassle.
One of the easiest ways to begin your emergency money stash is through automatic payments. Setting up automatic savings involves moving a certain amount of money from checking to savings. This can happen on a set day of each or month or on regular intervals. You can pick as low or high an amount as you’d like. While putting aside $50 twice a month may not seem like much, you’ll have $1,200 saved by the end of the year.
Save through employer
You can similarly put aside emergency cash through your employer. You can elect to move a fixed amount of money each pay period to an emergency savings account, typically through direct deposit. It’s usually possible to divide your paycheck into separate accounts.
Receive a tax refund this year? Instead of splurging on a big-ticket item, put that money aside as a financial cushion that will afford you peace of mind. While this might take an enormous amount of willpower in the short term, you’ll be very glad you did should the unforeseen arise.
Can an emergency fund get too big?
It’s clear how important having a savings account is. But it’s also possible for your emergency savings to become too large. You want to make sure that you’re doing a cost-benefit analysis of saving for an emergency fund versus other options for your money.
How overfunding can make you lose money
Overfunding your savings account can make you miss out on other saving opportunities. The best strategy if you have enough savings is to have a diversified portfolio mixing low risk accounts, such as discussed above, with higher risk investments such as in the stock market. For example, if you have the chance to contribute to a retirement account like a 401(k) that is tax-advantaged and can be invested in the stock market, while also putting money aside in savings, that’s a better strategy for your money.
Ideas for excess funds
Excess emergency funds could be stored in a 401(k) as mentioned above, or or an IRA. The maximum contribution amount to an IRA in 2020 is $6,000 for those under age 50. The difference between a 401(k) and an IRA is that a 401(k) is tied to your employment while an IRA is an individual account that has nothing to do with your job.