Is your personal emergency fund in place and ready to serve its purpose in times of need? If not, don’t feel alone because the majority of working adults either don’t have a fund at all or have one that is only partially full.
If you’re in any of those groups, it’s simple enough to get down to business and create your emergency fund. But, before doing that, be sure to know where you’re headed. For instance, what is an emergency fund, anyway? How large should it be? Where should this “rainy day” emergency money be stored? When should you tap into an emergency savings bank account? How long should it take to complete it? And, how in the heck is an average person supposed to load up an emergency savings fund?
That’s a lot of questions. Taking them one by one is the smartest way to get started. By the end of the discussion, you should be armed with all the information you need to build your very own emergency savings fund.
What is an emergency fund?
An emergency savings fund, or emergency savings account, are special savings accounts that you create with your own money. There’s no “legal” definition, which means that what you call an “emergency fund” and what someone else calls it might be two different terms for the exact same thing: a stash of emergency money for an unexpected purpose.
One of the most common reasons a working person creates and emergency fund is to build a financial cushion in the event of extended unemployment. That’s just one of the reasons that most experts measure the size of an emergency savings account in terms of monthly income it can cover.
In textbooks, financial guides, and other authoritative sources, you’ll hear a range of suggestions for how large an emergency savings bank account or fund should be, but the size is nearly always calculated as some multiple of monthly household income.
Why have an emergency fund?
Why should everyone have an emergency savings fund? There are lots of reasons, most of which are related to unexpected events like unemployment, a fire or flood, death of a working parent, unplanned medical expenses, and more. The term “emergency savings” is apt, because it describes both the function and form of such an account.
Whatever warrants being called an “emergency” in your life is nearly always a sufficient reason for using the fund. And, the money in it is actually a form of savings. Years ago, people routinely referred to a secret stash as their “emergency money,” and often stored the capital in their homes. Hence the reference to folks who store emergency savings cash in their mattresses, cookie jars, floor boards, and walls.
In short, families and individuals have been storing extra money away ever since there’s been money to store. Greek storyteller Aesop wrote his famous fable, “The Ant and the Grasshopper” nearly 2,600 years ago, so the concept of maintaining an emergency fund is not at all new. The idea has endured because of the basic human urge to be prepared in times of need, as was the ant, and avoid being like the grasshopper, who stored no food for the long winter.
How much money should I have in my emergency savings fund?
How much money do people put in a typical emergency savings account? It varies, but the better question is, how much money *should* they put into an emergency savings fund? Again, there are various estimates from expert sources, including CPAs, financial advisors, and consumer counselors.
Plus, the amount differs, depending on your circumstances and financial means. For example, if you earn in excess of $100,000 annually, your emergency savings account should be larger than one for a person earning $35,000 per year. But, income is just one of many parameters that can act as a guide. Your needs are another.
Fortunately, there’s a good rule of thumb when it comes to deciding how much in emergency savings you should have. Some formulas use monthly income, but a more accurate method is to use a multiple of monthly income. On average, aim to have at least three times your monthly income in an emergency fund.
Where to store emergency money?
The term “emergency savings account” implies that there should be a formal “account” at a financial institution, and in many cases that is true. However, it’s important to remember that you can store the emergency money anywhere you wish. But, make certain that it’s as safe as possible from theft, fire, floods, and mismanagement.
For the vast majority of people who stash emergency money away for a rainy day, it’s unwise to keep it at home, even if you own a security safe. Homes are robbed, endure fires, are subject to floods, and even are destroyed by earthquakes. All those things can defeat the purpose of keeping your emergency savings in your home.
Alternately, safe deposit boxes at banks are a good choice for folks who are not so concerned about earning interest. In fact, many people choose to split up their emergency fund into two parts, keeping some of the money in a bank savings or CD account, and a portion of it in a safe deposit box.
Building an Emergency Fund
For most people, the key question is, “How to build an emergency fund the right way?” The reason the question is so vital is because there are many ways to build a fund. For some working people, it could take in excess of two years to create an emergency fund that fulfills their financial needs.
For others, a few months might be all it takes to load an emergency fund with a sufficient amount of capital. Consider making regular deposits to your emergency fund until it is fully funded. Treat it as you would any other financial obligation, like a car or house payment. Making regular, planning deposits in this way over a number of months or years makes the entire process much easier.
Creating an emergency fund can be a challenge even for high-income individuals. Setting aside three or more times your monthly income entails careful budgeting, smart planning, and personal discipline. But, the rewards of having ready access to a sufficient quantity of emergency money is well worth the effort.
Steps for Building an Emergency Fund
What are some general steps for setting aside emergency money? No two people use the same system, but you can get started by using some or all of the suggestions below:
- Decide On Size: Examine your current financial situation carefully. Do you have any room for emergency money to set-aside in your monthly expenses? If not, then you’ll need to trim some fat out of the budget or increase your income. Many people take on temporary, part-time work in order to add money to the fund. If you set a goal of saving three months’ income, for example, then you’ll be in a position to see exactly how much needs to be put aside each month.
- Re-Do Your Budget: As noted above, there’s a possibility you’ll need to reorganize your budget in order to store enough emergency money. This is the time to slice fat out of the expense side and reconsider every line-item, especially the ones related to discretionary spending, like eating out, vacations, and more.
- Decide On Payment Schedule: Once you’ve nailed the size of the fund and pared your budget, figure out what “monthly payment” you can afford. Here, you can calibrate the amount by spreading out the amount of time to complete the fund. For example, if you decide on a fund size of $8,000, break up the amount into payments. In this case, a monthly contribution of $223 would finish the fund in three years.
- Write Rules For Use: Make a written list of rules about the fund. This step will help keep you honest and will prevent the urge to raid the fund for improper purposes. Typical rules include a list of specific reasons to use the money, including obvious and common situations like unemployment, losses from theft, or destruction of your home.
- Arrange For Storage: Decide to keep the money in a safe place, preferably not in your home. Banks and safe-deposit boxes are popular choices.
- Review Size Annually: As your income and expenses change, don’t forget to update monthly contribution levels. For instance, if you receive a raise or bonus, consider making larger contributions to the fund in order to finish it ahead of schedule.
When to use your emergency fund?
You never know what life will throw at you. If you’ve been diligent and have financially prepared for any hardships you should already have your emergency fund built out to cover at least 3 to 6 months. The key to using your emergency fund is to set strict rules with how you spend the money.
Keep in mind if you’ve had to use your emergency fund, replenishing it is key to making sure you have access to savings the next time you’re in need.
What shouldn't you spend your emergency fund on?
Once you’ve designated it for emergencies, you owe it to yourself to spend it only when it’s absolutely necessary. Infrequent expenses can sneak up on you and sometimes feel like a legitimate emergency. However, even annual bills and routine spending can—and should—be planned for along with your regular monthly expenses.
Before touching your emergency fund, always ask whether the money is going toward something essential for living. Leisure spending should always be funded with your regular wages, side income, or separate savings.
Building an emergency fund is a financial goal itself, not a source of funding for another financial goal. If you clear out your emergency savings for a major expense, you’ll have nothing left to cover you for a rainy day, and what seemed like a sound financial decision at the time could turn out to be a major mistake.
With all this said, you shouldn’t use your emergency fund for:
- Periodic or Expected Expenses: Holiday or Birthday Gifts, Car Registration or Taxes.
- Non-Essential Spending: Phones, Clothes or Vacation.
- Larger Financial Goals: Down Payments, Retirement or Investing.
What should you spend your emergency fund on?
Sometimes you can fall on the opposite end of the spectrum, completely afraid to touch your emergency fund, even when it’s truly necessary. As a guideline, you can tap into your emergency savings for unexpected, necessary, and urgent spending.
You should spend your emergency fund on:
- Living expenses after a job loss or pay cut
- Major car repairs after an accident
- Emergency home repairs
- Emergency, necessary medical expenses
- Unexpected, essential travel