Emergencies happen without warning. Even the most reliable car can suddenly need hundreds of dollars in repairs, and medical issues can significantly increase a person’s debt overnight. Yet the vast majority of Americans lack an emergency fund and are unprepared for any of these events. According to a survey conducted by GoBankingRates, sixty-nine percent of Americans have less than $1,000 in savings.
For younger Americans, the statistics are even more dire. Only twenty-seven percent of those between the ages of 18 and 24 have set aside $1,000 or more to save for a rainy day. With millennials holding a large chunk of U.S. consumer debt, thanks to school loans and a sluggish job market, it’s no surprise they lack extra money to save each month. But by failing to set money aside, they’ll likely only dig themselves into a deeper hole.
Before you can hatch a plan to establish and grow an emergency fund, you’ll first need to understand what is an emergency fund and how much you should set aside. This guide compiles various expert theories to help you decide which approach works best for you.
What Is an Emergency Fund?
People often learn to build savings from a young age, with parents encouraging them to put extra coins in a piggy bank or stockpile their allowance. As you get older and land your first job, you may even hold onto those concepts, learning that if you save some of your hard-earned money, you can buy high-dollar electronics or other luxuries.
At some point, though, inevitably that excess money dries up. It could even start with that first job, as you find the cost of gas and meals cutting significantly into the small weekly wages you earn. If not, maybe you find funds getting tight in college or just after graduation, when you first face the realization that rent, groceries, insurance, and loans wipe out your entire paycheck, if not more.
When that happens, it’s only natural to wonder how to build an emergency fund without a single cent left over at the end of the month. Whether you set aside a dollar a week or $100 a month, it adds up over time.
The best answer to, “What is an emergency fund?” is that it is an adult’s way to save for a rainy day. When an unexpected expense comes up, instead of going further into debt using credit cards, someone with an emergency fund can take the money out of that savings account, rather than borrow it from a financial institution that will also pile interest on top of the amount.
With the right plan in place, though, even the most cash-strapped person can set up a monthly savings plan that gets results. But figuring out how much to save and how much to keep in savings at all times can be complicated. Once you have that formula in place, there are tools that can help make it easy to push some of your earnings into savings as soon as you’re paid, and soon you’ll have a fully-funded emergency fund that prepares you for anything life can throw your way.
The Importance of Emergency Funds
There are many benefits of having an emergency fund in place, but perhaps the most important one is that it helps you avoid debt. With credit card interest rates averaging over fifteen percent, every dime of debt you accrue costs you. If you charge a $500 car repair, that fifteen percent annual percentage rate (APR) will be prorated each month, costing you on average $75 extra a year unless you can pay it off.
An emergency fund, on the other hand, accrues interest each month. Even if it’s a small amount in a savings account, that beats paying an additional $5-$10 a month on that $500. Best of all, as soon as that $500 comes out, you’ll be working toward putting it back into your savings again based on the emergency savings plan you’ve created.
Basic emergency funds are meant to cover life’s little emergencies, such as repair bills and medical issues. However, once you have a basic fund in place, it’s time to start thinking about bigger emergencies. Seventy-five percent of Americans are afraid of losing their homes, a report from the NHP Foundation found, with almost forty percent citing job loss as a top reason they might suddenly become homeless.
Even if you’ve found a secure job, the risk of unexpected unemployment is always there. Only half of all small businesses with employees survive more than five years, according to the Small Business Administration, and one-third fail within the first two years. Even if you’re working for a large corporation, there’s no guarantee against being fired or laid off due to corporate changes or personal differences.
While discussing the possibility of unemployment may seem depressing, professionals who set money aside for sudden job loss can protect themselves against going deeply into debt or, worse, falling into foreclosure. In addition to having to find somewhere else to live, a foreclosure will remain on your credit report for seven years, making it more difficult to qualify for an apartment or purchase cars and other items. An emergency fund can supplement any unemployment payout you receive as you search for a replacement job.
How Much to Keep in Savings
The first step toward building an emergency fund is to determine exactly how much you’ll need to cover life’s little surprises. The exact amount can vary from expert to expert, so it’s important to take in all the advice and decide for yourself. To start, set a goal for yourself to save up enough to cover issues like car breakdowns and calculate what the average repair bill might be.
In his Baby Steps plan, financial expert Dave Ramsey recommends starting with a $1,000 emergency fund. This $1,000 gives you something to rely on as you work on the next phase of his plan: gradually paying off your debt. Once you’ve achieved debt-free status, aside from a 15-year mortgage, you’re then ready to begin saving three to six months of expenses to better prepare you for longer-term setbacks like losing a job or having a serious medical crisis.
Another respected financial expert, Suze Orman, separates the emergency fund from the plan to pay off debt. She recommends consumers simply start directing a portion of their income toward an account, with a goal of eight months of living expenses. She also urges you to push yourself to set more aside as time goes on to meet your long-term goals more quickly.
One mistake many people make in calculating how much to keep in savings is that they try to replace their full salary. If you’re saving six months of living expenses, you need only consider what you would spend on groceries, your mortgage or rent, and other necessary bills, not what you currently make. Chances are, if you were out of work, you’d live more frugally than you live now.
To calculate what a fully-funded emergency fund should look like, list your current monthly expenses and determine what you might reduce if you were out of work. You may find that you’d rather save a little extra and still be able to enjoy a night out once a week or an annual vacation. If you build those things into your emergency fund, you won’t feel guilty if you occasionally treat yourself.
How to Save
The prospect of saving even $1,000 can feel overwhelming if you’re living on a tight budget. However, it’s important to realize how little it takes in the short term to make a big difference long term. If you set aside $25 a week, you’ll have $1,300 within a year. Push that amount to $100 a week, and you'll build savings of $5,200 by the time next year rolls around.
Your bank may already offer a feature that helps you determine where your money goes each month. If not, use an app that tracks it for you. At the very least, manually review your expenses and record them using an Excel spreadsheet or pen and paper. Find small areas where you can make budget cuts without dramatically impacting your basic needs. That $3-$5 cup of coffee you buy every morning could give you an extra $1,000-$1,825 a year. Making your lunch instead of dining out every day could bring an additional $2,000-$4,000 in savings, according to Money Crashers.
In addition to your dining habits, you can also find extra money by living frugally. Look for apps that can help, such as those that offer coupons for products you’re buying anyway and solutions that help you find the best gas prices in town. Also look for opportunities to buy generic when you’re shopping and take the time to shop separate grocery stores to get the best deals at each one. Calculate your cost savings for each of these changes and put that extra money into your emergency savings fund.
Perhaps you're already living frugally, and you still don't have an extra dime to save for a rainy day. When helping instruct their clients on how to build an emergency fund, many financial experts suggest considering a second job. Maximize every hour of that extra work by choosing a side occupation with a high hourly wage. Often this is earned through positions that bring in immediate cash through tips, such as bar tending or waiting tables. You can also make extra money without relying on an employer by offering to clean houses for neighbors or babysit dogs for people in your area who are going away on vacation.
Where to Save
Once you’ve determined how to build an emergency fund, it’s time to figure out the best way to set that money aside. Your first inclination may be to just channel it into your existing savings account, but you’ll likely only see an interest rate of 0.01 to 0.06 percent on the money you put in. Check with your financial institution on all your options, but also research interest rates offered by other banks in your area, as well as online. With today’s technology, you’re no longer confined to banks in your town.
To help your emergency fund grow faster, you may consider investing it into something with a high rate of return. Your top priority in doing this is to ensure your funds are accessible without a long wait or excessive penalties. Chances are, you won’t have months of advance notice if your job is suddenly going away and any day-to-day emergency will mandate you have funds immediately.
In addition to being liquid, you should also choose an investment option that is safe. Putting your emergency into high-risk stocks may give you the potential of significant earnings, but you also could lose everything you’ve put in. start saving, don’t risk a setback that might cause you to give up on an emergency fund altogether.
Here are a few options if you’re trying to build savings:
- Traditional savings account—Although this is a no-risk option since your funds are insured, you'll also earn a negligible amount each year on the money you have in the bank.
- CD—With an APR of one to two percent, Certificates of Deposit (CDs) can bring the highest return on your money with the lowest risk. If you’re willing to put your money in for a longer term, you may be able to secure an even higher rate. Since CDs must remain untouched for a fixed period to avoid a penalty, this may be an option for a portion of your emergency fund, with the amount you'd need for the first few months of an emergency set aside in a more liquid type of account.
- Money Market—Money Market accounts can pay interest rates as high as CDs, with an added benefit of liquidity. However, the rates paid out on money markets can vary from day to day, because they follow the fluctuations of the market. There is often a minimum deposit required to start this type of account, so it may be something to consider once you already have a portion of your emergency savings fund in place.
- Investments—Some financial experts will direct clients to a fully-diversified portfolio for the biggest possible reward. Betterment advises investing in a moderate risk portfolio with a thirty to forty percent stock allocation. The company does admit to some risk with any stock market investment, but they’ve run the numbers and have determined the reward outweighs the risk. However, getting your money out as quickly as you might need it could be challenging, in addition to the possibility you face of losing some of the money you put in.
Auto Save Features
Having the willpower to manually set aside money each paycheck can be difficult for many people. As emergency funds have grown in popularity, though, financial institutions have found that automatic funds transfers are a popular feature. Many consumers can find an area of their banking site that allows them to set up recurring funds transfers at increments that work best for them. For some, though, the issue is seeing that money in their savings account every time they log in. If there’s something you want to purchase, you may see those dollars adding up and feel tempted to dig into your emergency fund to buy it. If willpower is an issue for you, consider having your funds set to transfer to an account at a completely different bank, where you’ll forget about it until you need it. The harder it is to use that money on a daily basis, the more likely you’ll be to leave it untouched.
If your bank doesn’t offer this feature, check with your HR department at work to see if they can help with your monthly savings plan. Many companies now offer to take a certain amount out of every paycheck and direct it into an account of some type. Your employer may be able to direct your funds to go to two different banks, especially if your place of employment has a relationship with a local credit union.
As a replacement or supplement for these auto save options, consider apps that now make saving even easier. Acorns rounds up every purchase you make to the nearest dollar, directing the extra change into a diversified portfolio of exchange-traded funds (ETFs). Another app, Digit, monitors your daily spending habits and moves money into your savings account of choice when it sees that your checking account can handle it.
Start Building Your Emergency Fund Today
A fully-funded emergency fund can offer a peace of mind that is worth more than anything that money could buy. With just a small weekly savings, you can get started on a savings account that will help you with any emergency, whether it’s car repairs or sudden unemployment. We’ve covered the importance of a rainy-day fund, how much to save, and where to save your money. Now it’s up to you to take action!
Leave a Reply