What is an emergency fund, and how is it different from regular savings?
A savings fund is a general bucket of money saved for a variety of goals—either short-term, such as for a car or vacation, or long-term such as college or retirement. An emergency fund is a specific savings fund focused on helping cover life’s financial surprises. Though life is wildly unpredictable, an emergency fund can help with things like:
- Job loss
- Medical or dental emergency
- Unexpected home repairs
- Car issues
- Unplanned travel
Why have an Emergency Fund?
According to a 2021 survey by Bankrate, nearly 4 in 10 American’s said they would need to borrow money to cover a surprise $1,000 bill. And in the same survey, they found even more sobering statistics, such as the fact that 51% of American’s have less than 3-months of savings and 25% have no emergency funds at all—that’s up from 21% in 2020.
An emergency fund is an important part of your overall financial well-being as it allows you the financial stability to work through unexpected events. Without emergency savings, many would have to take on high-interest debt via personal loans or credit card debt in order to cope with sudden and unforeseen bills. A proper emergency fund not only lessens the financial burden of unplanned expenses but can help your mental health by lowering the stress associated with such unexpected events. After all, getting a flat is already stressful enough, why add the financial worry on top of that?
How Much Should You Save?
In order to maximize your chances of success in building an emergency fund, you have to select an exact number. Now the final number varies from person to person and depends heavily on your personal circumstances with many experts saying 3 to 6 months of living expenses is an appropriate emergency savings amount. To get started you will want to calculate your average monthly expenses—being mindful of what is a fixed cost, like rent and utilities, and what are expenses you can cut quickly if needed, like eating out or subscriptions.
Once you have your average monthly number, we can multiply your monthly number with a number between 3 and 6 to get to your final target amount. For example, an individual with no dependents can get by with a smaller emergency fund than a person with a family to support. Additionally, individuals with stable salaried jobs can likely have a smaller emergency fund than individuals with more unpredictable income streams. Taking your personal circumstances into consideration will help you determine what final multiple to apply on your original monthly number.
As a concrete example, say an individual has a fixed monthly expense of $2,000 a month (rent, insurance, food, and utilities) and falls into one of the two situations:
- Salaried job, with no dependents: A multiple of 3 is likely appropriate, meaning their emergency fund goal should be roughly $6,000 (3 x $2,000)
- A small business owner with dependents: A minimum multiple of 6 is likely a good starting point, meaning their minimum emergency fund goal should be roughly $12,000 (6 x $2,000)
Once you’ve determined exactly how big your emergency fund should be, now you can get started or add more to an existing fund if you found that your current amount saved is not enough.
How to Build an Emergency Fund
At this point, you might be staring at a large number, and for those living paycheck to paycheck, the number might seem unattainable and even discouraging. But regardless of your circumstances, I urge you to get started and don’t give up! Something is always better than nothing!
If you are starting out, intimidated, or unsure please trust me, and let’s break it down into small manageable steps:
- Set small incremental goals – You don’t have to have 3 to 6 months in emergency funds today, you can build towards that! Start with saving towards $100 dollars, then 1 week’s worth, 2 weeks’ worth of savings, and before you know it you’ll have a whole month’s worth of savings and more importantly, you’ll have developed good powerful money habits.
- Small and consistent contributions – Start with a relatively small amount that will not stress your budget and you know you can easily stay with. Then commit to putting away that amount on a consistent basis; either weekly, per paycheck, or at the end of every month. The initial amount and frequency do not have to be large, it simply has to be something you can commit to doing.
- Automate the process – Now that you’ve started saving, you need to continue saving in order to grow your emergency fund. The best way to keep the habit going is to set automatic and reoccurring deposits into your dedicated emergency fund (it’s best to create an entirely separate savings account just for emergencies).
- Keep track and adjust – With your dedicated emergency fund established and growing, monitor your monthly spending and see if you can incrementally increase your savings to help you achieve your goal faster.
Saving too Much
Though saving too little can cost you, saving too much can also create issues! An emergency savings fund should be just enough to help you overcome unforeseen expenses, but it should not be built into a large pile of cash. Too much idle money will cost you, either through reduced purchasing power due to inflation over time, or opportunity cost as the money sitting earning little interest could instead be invested earning dividends and capital appreciation.
My Approach
I have an unorthodox approach to addressing this issue, one that borrows from the concepts of CD ladders and allows me to efficiently have an emergency fund that covers 7 to 12 months’ worth of expenses. Now, this is possible because I live significantly below my means, and because I use a combination of no-risk, low-risk, and moderate-risk setups to park my money.
It’s not for everyone, but to find out more about my approach on this topic, read here.
Conclusion
Hopefully, by now I have convinced you about the importance of having a dedicated emergency fund and hopefully, you have an exact number to work towards along with concrete steps of how to reach your goal. Though it can appear daunting, I promise you it is well worth it! By the end of the process, you won’t simply have emergency savings, you’ll have the peace of mind knowing you can navigate life’s challenges and you’ll have developed valuable financial skills such as being intentional, focused, and living below your means.
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