Emergency Fund: How to Build One and Why You Need to
An emergency fund is a must for all American households. It’s as important as a savings account (but not quite the same thing) and it’s one of those things you always wish you had when you need it. So, do your future self a favor by creating an emergency fund today!
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What is an Emergency Fund?
An emergency fund is a sum of money designed to help you in your time of need. Also known as a “rainy day fund”, it’s there to help you when you lose your job, struggle with bills or have some other need.
The idea of an emergency fund has taken on a rather strict and standard form in the last few years. If you google the term “What is an Emergency Fund” you’ll see countless articles stating it’s a fund designed to pay housing costs/bills and that it covers between 3 and 6 months of living expenses.
But it doesn’t need to be that exact and you shouldn’t impose limits on it. An emergency fund can help you when you’re in dire need of funds and can’t pay the bills, but it can also help you to clear debt, fund an education or pay for some other necessary expense. If you get into a good rhythm, save more and prepare for an even rainier day; if you’re struggling to save anything at all, then just focus on putting the smallest amounts to one side and try to build from there.
Don’t worry about the “3 to 6 months” thing, just focus on what’s easier for you.
When to Start Building an Emergency Fund
The best time to start creating your emergency fund is when you need it the least. In other words, prepare for the rainy days while the sun is still shining. It’s easy to spend money when you have it and to assume that the good days will continue forever. This is how so many Americans find themselves going from privilege to poverty in a few short weeks.
Prior to 2008, for instance, many Americans were spending freely, investing like there was no tomorrow and living off credit and promises. When the recession hit, they were faced with mounting bills, reduced opportunities, and repossessions, taking all their money away in a heartbeat and leaving them destitute.
Never assume that the good times will keep rolling. Start sacrificing some of those luxuries to build an emergency fund and prepare for whatever’s around the corner. If the good times really do keep rolling, and you accumulate huge wealth and vast savings, simply cash that emergency fund and use it to pay for a vacation.
Anytime things are going well, or you have some sense of financial stability, put more money to one side just and make sure you’re covered when your seemingly impenetrable foundation shakes.
How Much do you Need?
As discussed above, it’s often said that you need at least 3 months’ worth of living costs. This is a good guide to start as giving yourself a fixed goal will make it easier to achieve that goal. It will give you more motivation and a sense of accomplishment when you achieve it. However, you shouldn’t stop then.
Once you achieve 3 months of savings, aim for 6 and then 12. After that, you can start funneling any extra funds you have into a savings account to be used for non-emergency purposes.
To calculate 3 months of living expenses, just add all of your outgoings for a single month and multiply by three. For example:
- Food = $400
- Rent = $800
- Bills = $500
- Debt Payments = $500
- Total ($2,200 x 3) = $6,600
Where to Put an Emergency Fund
An emergency fund can be placed in an account that meets all of the following criteria:
- Accumulates interest
- Is safe from any market risk
- Can be accessed when you need it
Also, this is the 21st century, so don’t store the money under your mattress or floorboard. Cash won’t generate interest and it’s at risk of fire and theft.
How to Save for an Emergency Fund
Now that we’ve discussed the importance of building an emergency fund, it’s time to focus on how you can save those extra pennies.
Set a Goal
We function better when we have short-term goals and can focus on day-by-day as opposed to quarter-by-quarter. Therefore, instead of setting the goal of saving X amount of money every 6 months, break it down to a monthly or bi-weekly savings goal.
If you have given yourself the goal of saving $2,000 every three months and have an opportunity to take an expensive vacation on week 1, there’s a good chance you’ll accept, spend freely, and let your future-self worry about meeting the target. By focusing on a bi-weekly savings goal of $300 you’re more inclined to skip that vacation, tighten your belt and deal with the issue now and not later.
Round-Up and Keep Change
Get yourself a piggy bank or an app like Acorns and you could save a few hundred dollars extra every year.
A piggybank makes good use of all those coins you have lying around and means you will be more inclined to keep them, as opposed to tossing them away, leaving them in old clothes or putting them towards pointless purchases.
Once the piggy bank is full, take it to your bank, drop it in your savings account, and start filling it again.
Acorns works in a similar way but will result in greater savings. It rounds up all of your purchases to the nearest dollar and places the extra money in an investment account. If, for instance, you spend $3.50 on coffee every weekday morning and $2.50 on a doughnut every weekday evening, you’ll save $240 extra every year.
Of course, that’s your money you’re investing so you’re not really saving anything. However, it’s money you won’t miss and money that automatically grows your investment account and can serve as an emergency fund all of its own.
If you’re struggling to get your head around the viability of this process, imagine that your favorite coffee shop and donut shop suddenly increase their prices by $0.50. It’s a small amount and probably won’t impact your decision to purchase. After all, it’s only $0.50 extra per item or $1 per day. And that’s exactly the mentality behind Acorns, only the extra money is going towards your future and not the retailer’s profits.
You might think that you can’t possibly trim any of your expenses and that you’re stretched to the limit, but if you take a step back and assess your finances honestly, you’ll likely realize that you can save thousands of dollars a year by making a few small sacrifices.
As an example, the average American household spends over $3,000 on dining out, close to $1,500 on groceries they eventually throw away, and nearly $5,000 on vacations. On top of this, they spend thousands on unused subscriptions, lottery tickets, and unnecessary purchases. And if you smoke, that’s another expense that could be costing you a fortune.
It’s tempting to spend cash windfalls when they come. It’s extra money that you didn’t know was there, so you convince yourself that it’s okay to spend on a vacation or a brand-new computer. But that money could establish your emergency fund in one fell swoop, allowing you to save towards something else and greatly reduce the time it takes to reach your financial goals.
If you get a tax refund, inheritance or lottery win, think about investing the money for your future instead of blowing it in the present.
Adjust as Needed
Your emergency fund goals should change as your circumstances do. If you have more bills to pay, you’ll need to save more money; if you get a promotion at work, you will have more disposable income to invest.
By the same token, if you’re struggling to save and have been hit with some unexpected bills, think about halting or reducing your emergency fund payments. Assess your situation every couple of months and adjust your emergency fund as needed.