Understanding Emergency Funds: Why and How to Build One

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Understanding Emergency Funds: Why and How to Build One

An emergency fund is a crucial part of your personal financial plan. You’re already aware that you need one, but still, it’s easy to put off starting one. Maybe you think you don’t have enough extra money to put towards an emergency fund. Or you don’t like the idea of locking up money in a bank account when it could be used for current needs or invested elsewhere.

But an emergency fund is essential protection against unexpected costs and financial setbacks. Let’s explore what an emergency fund is, how much you should save, and creative strategies for quickly building up your emergency fund.

What is an Emergency Fund?

An emergency fund is money set aside in easily accessible places (like a bank account) to cover unplanned expenses, financial emergencies, or losses of income. The point is to ensure you have access to quick cash without selling investments or borrowing money when something unexpected happens.

Ideally, an emergency fund will let you cover three to six months of living expenses. This figure often depends on your stability and security within your employment.

Why You Need an Emergency Fund

1. To cover unexpected expenses

Your car might suddenly need a new transmission. A family member may need help covering their medical bills. These are the types of unexpected costs an emergency fund can cover, giving you a safety net when you need it most.

2. To prepare for possible income loss

There are many reasons why you might lose income, from getting fired to taking advantage of an opportunity for personal growth that comes with a temporary pay cut. Having an emergency fund can help you cover living expenses while you deal with the loss of income or seek out new employment.

3. To avoid going into debt

Without an emergency fund, you might be forced to borrow money or use credit cards to cover unexpected costs. Credit cards charge high-interest rates, meaning you’ll pay much more for the things you really need. Borrowing from friends or family can put a strain on relationships.

How to Build an Emergency Fund

1. Set a goal

Determine how much you need. As a general rule of thumb, aim for three months of essential living expenses as a minimum. Essential expenses are things like housing, transportation, and food. If you’re the sole income provider for your family, are self-employed, or work in a highly volatile industry, you may want to build a larger emergency fund – somewhere between three and six months’ worth of living expenses is a good target.

2. Track your spending

How much you should save depends on your personal situation. To figure out how much you can afford to put towards an emergency fund, track your spending for a month. See what expenses are essential and where you can make cuts. Side gigs or part-time work you can turn to in an emergency can also reduce the size of the emergency fund you need.

3. Open a separate account

You need quick access to your emergency fund, so it’s best to keep it in a bank account. You may even want to keep it in multiple accounts for diversity and accessibility purposes.

4. Automate your savings

You won’t worry so much about the amount you’re putting into your emergency fund each month if the process is automatic. Set up a recurring transfer from your everyday account to your emergency fund account (or multiple accounts) so that you don’t even need to think about it.

5. Look for creative ways to save

Before you start throwing all your extra money towards an emergency fund, consider that some ways of saving are more effective than others. Here are some ideas for creative ways to boost your emergency fund:

• Direct deposits. Ask your employer to deposit your paycheck directly into a high-yield savings account.

• Skip a couple of zeroes. Automate your savings so that you save whole dollars; round up every payment you make with a credit card to the nearest dollar and transfer the spare change to your emergency fund.

• Pay yourself first. Whenever you receive any extra money, treat your emergency fund as a priority and pay yourself that amount first.

• Exploit fluctuations in currency exchange rates. You can buy currency at a discount and lock in the exchange rate if you know you’ll need the money in the short term.

• Use your talent. Anything you can make or do yourself, without having to buy, is a potential saving. These skills can range from fixing your car to sewing your clothes.

• Tax refunds, rebates, or incentives. Any tax refunds, rebates, or incentives related to your employment or business can go straight to your emergency savings.

6. Understand inflation

Inflation erodes the value of money over time. Therefore, the amount of money you need for an emergency fund today might not be enough in five or ten years. Account for inflation when determining how much money you need for your emergency fund.

7. Don’t sacrifice your retirement

When it comes to prioritizing your savings, emergency funds are more important than retirement accounts in the short term, but they shouldn’t detract from retirement savings.

8. Seek help when you need it

If you’ve minimized your expenses, cut back on spending, and still can’t find places to redirect to your emergency fund, it might be time to seek professional help. A financial advisor can provide valuable insight into your finances and may uncover areas to save you didn’t realize were there.

9. Reevaluate your emergency fund needs

The amount you deemed necessary for your emergency fund at the start of your journey may not be accurate now. As you progress through life, evaluate the size of your emergency fund based on life events, financial changes, and your evolving personal needs.

10. Use emergency funds only for emergencies

Once you’ve built up your emergency fund, it can be tempting to use it for non-emergency spending. Try to resist this temptation unless you have an actual emergency. Your emergency fund is only helpful if it’s there when you need it the most.

Conclusion

Your financial well-being depends on having an emergency fund. By understanding how emergency funds work and how best to build them, you can ensure you have the financial safety net you need. For most people, starting is the hardest part, so be patient with yourself. If you stick to your savings strategy, you’ll be left with a comforting cushion of money set aside for whatever life may bring.