At some point in your life, you were probably told to "save for a rainy day." It's a way of advising you to put money aside to get you through any tough times that might be on the horizon.
If the recent past has taught us anything, it's that economic emergencies aren't confined to a particular season. And those rainy days you were warned about? They can sometimes stretch out for months or even years.
That's why now, perhaps more than ever, you need an emergency fund to help weather life's unexpected financial storms.
What is an Emergency Fund?
An emergency fund, also known as a contingency fund, is money set aside specifically to pay for any large, unplanned expenses you may encounter. It serves as your financial safety net, ensuring you have the resources available to deal with the situation without incurring debt or struggling to pay your bills.
What an Emergency Fund Should Be Used For
Emergency funds should be used for exactly that — emergencies. True financial crises are those major, unexpected curve balls that disrupt your personal status quo.
Emergency funds are often used to cover:
- Unforeseen medical and dental expenses
- Major home repairs (HVAC system, plumbing, electrical, etc.)
- Home appliance replacements (for necessity, not aesthetics)
- Extensive car repairs
Quite simply, emergency funds are for life events and expenses that are unforeseeable, unavoidable, and time sensitive.
What an Emergency Fund Should Not Be Used For
An emergency fund should never be used for anything other than an actual emergency. Don't confuse it with long-range savings for expenses that are reasonably foreseeable, even if they might be considered essential.
If you expect your emergency fund to protect you during times of real, unpredictable financial hardship, you must resist dipping into it for non-emergencies such as:
- Down payments (including homes and cars)
- Credit card debt
- Gifts for special occasions and shopping sprees
Benefits of an Emergency Fund
The biggest advantage of an emergency fund is the protection it provides from life's "what-ifs." It won't prevent bad things from happening, but the economic safeguard will lessen the financial impact of unexpected expenses and events.
An emergency fund can also help to:
Provide Peace of Mind
Unplanned challenges induce stress. An emergency fund alleviates some of that stress, allowing you to focus on the emergency itself rather than worrying about how you'll make ends meet.
An emergency fund can keep you from depleting your regular savings or taking on additional debt by relying on credit cards or loans to get you through rough patches.
Spend More Judiciously
Setting aside money to be used only in a financial emergency reduces the amount you have for discretionary spending, which can improve your overall financial well-being.
How Much Emergency Fund You Should Have
According to a 2020 Bankrate survey, only 41% of U.S. adults would be able to use their savings to cover a $1,000 emergency.
Your lifestyle will determine how much money you should keep in your emergency fund. A good rule of thumb is to have enough reserves on hand to cover three to six months' worth of expenses if you weren't bringing in any income during that time.
When calculating your emergency fund "number," factor in your rent or mortgage, utilities, car payments, groceries, and other essential costs. You don't have to include dining out, entertainment, or new clothing since those should be considered non-essential when you're facing a financial emergency.
So, if you spend roughly $4,000 each month on essential living costs, your emergency fund should have at least $12,000 to $24,000 in it.
That said, you may want to put aside enough to cover a few hundred dollars above your monthly emergency fund minimum. This additional cushion will help to reduce or eliminate additional stress.
Where to Put an Emergency Fund
Despite what you may have seen in movies, glass jars and mattresses aren't ideal locations to stash your cash, particularly the kind you put away for a rainy day.
The best spot for an emergency fund is an interest or dividend-bearing account or a safe, short-term investment that allows you to quickly access money without facing penalties for withdrawals.
Here are some popular accounts for emergency funds:
Traditional Savings Accounts
A traditional savings account is a logical place for your emergency fund. You can access your money quickly, there are no withdrawal fees, and you can link it to your checking account for immediate transfers if you have both at the same credit union or bank. Plus, deposits are federally insured up to $250,000 by the National Credit Union Administration (NCUA) or Federal Deposit Insurance Corporation (FDIC), so your funds are safe.
Unfortunately, a regular savings account won't do much to grow the money you put in it. In fact, with most accounts paying on average 0.03% annual percentage yield (APY), the amount you earn in interest or dividends won't even keep pace with the typical 1% to 2% annual inflation rate.
High-Yield Savings Accounts
High-yield savings accounts function essentially the same as standard savings accounts with one main difference: the dividends they pay. High-yield savings accounts typically offer higher APYs, which means they earn more than regular savings accounts.
The biggest drawback to high-yield savings accounts is that most are only available through online banks. Since you can't go to a brick-and-mortar location to withdraw funds or make deposits, you'll have to use an account from a credit union or bank to transfer money in and out of a high-yield savings account. The delay in moving money electronically between institutions could put you in a bind if you need funds immediately when an emergency arises.
Money Market Accounts
Money market savings accounts make a lot of sense for emergency funds. They offer yields generally on par with high-yield savings accounts, and many allow you to write checks and use a debit card to access funds much like a checking account. Plus, money market accounts are federally insured and available from traditional credit unions and banks as well as online institutions.
On the other hand, money market accounts typically require a larger minimum deposit to open an account than other options. Also, some financial institutions may limit the number of withdrawals or transfers you can make to six per month, and many accounts charge a maintenance fee if the balance falls below a minimum level.
If you're looking for a safe investment vehicle where you can grow your emergency fund over time, a certificate may be the choice for you. Certificates usually offer better yields than both traditional and high-yield savings accounts, and they typically don't charge monthly or maintenance fees.
The trade-off for this enhanced earning potential is access to your money. A certificate requires you to leave your savings in an account for a set period, which ranges from 30 days up to 10 years depending on the term you choose. Once that term ends (known as maturing), you can withdraw your initial deposit and the dividends it accumulated over the life of the investment.
If you take money out of the account before the certificate matures, you'll be charged a penalty for early withdrawal. Fees vary depending on the financial institution, the term length, and the amount of dividends the certificate pays.
A Diversified Approach
Not sure which place is best for your emergency fund? Your best option could be to diversify your rainy-day savings.
Consider allocating some of your emergency cash to a savings account, a larger portion to a money market account, and sizeable chunk to a certificate. This will ensure you have funds you can tap into quickly for smaller emergencies and additional resources earning as possible for more substantial life events that might be on the horizon.
How to Start an Emergency Fund
The most important move you'll make when starting an emergency fund is the first one: committing to it. And the sooner you do so, the better.
Here are five additional steps to put you on a solid path to building a contingency fund:
1. Develop a Budget
If you don't already have a personal budget, create one. This will help you see where your money is going and determine how much you'll need in your emergency fund to cover expenses for three to six months.
2. Start Small
Set aside $500 to $2,000 to establish your initial fund. This will provide the money you need to handle a smaller emergency now while serving as the foundation of your rainy-day fund.
3. Save Consistently
Even if it's only a few dollars a week, get in the habit of regularly contributing to your emergency fund. Make it easier by having a portion of each paycheck directed into your savings account or automatically transferring funds every month.
4. Increase Contributions
As your income begins to grow, gradually increase the percentage you're saving or the amount of money you put into your emergency fund. Small increases lead to incremental savings that add up over time.
5. Maintain Momentum
Extended financial hardships may require more than six months' worth of savings, so it's usually a good idea to continue contributing to your emergency fund after you've reached your goal. The peace of mind alone is worth the added investment.
Time to Get Started
Financial emergencies are unpredictable, both in their timing and severity. So, if you haven't already, establish an emergency fund now to protect yourself and your family from rainy days in the future.
Take a Closer Look at Your Savings Options
See the wide range of accounts you can turn to for your emergency fund.