BUILDING AN EMERGENCY FUND
Life is unpredictable, and unexpected expenses can arise at any time. Whether it is a medical emergency, car repair, or sudden job loss, having a financial safety net in place is crucial. That is where an emergency fund comes into play. In this article, I will walk you through what an emergency fund is and guide you on how much you should set aside to weather life’s unexpected storms.
what is an emergency fund?
An emergency fund is a dedicated savings account or cash reserve specifically set aside to cover unforeseen financial emergencies. It serves as a safety net to help you avoid going into debt or making impulsive financial decisions when unexpected expenses arise.
Setting aside an emergency fund has many benefits, including:
Financial Peace of Mind: Knowing you have a cushion for life’s unexpected events can reduce stress and anxiety. It provides peace of mind and allows you to focus on your long-term financial goals
Avoiding Debt: Without an emergency fund, you might be forced to rely on credit cards or loans to cover emergency expenses, which can lead to high-interest debt
Protecting Your Financial Goals: An emergency fund protects your long-term financial goals by preventing you from having to dip into savings or retirement accounts when unexpected expenses occur
HOW SHOULD I PRIORITIZE BUILDING AN EMERGENCY FUND VERSUS OTHER GOALS?
Great question! If you have debt, your first priority should be setting aside a starter emergency fund. This starter fund should have between $1,000 to $3,000 worth of savings that can help you get through simple emergency scenarios, such as repairing a car.
After you save up for your starter fund, you should proceed by paying off your debt. It is only after you have paid off your debt that you will want to start building a fully-funded emergency fund with enough cash reserves to get you through a wide range of emergencies.
how much should I set aside in My FULLY-FUNDED emergency fund?
Determining the right amount to save in your emergency fund is important. Too big of a pile means that you lose out on potential earnings from investments. Too small of a pile and you might not have enough to cover an emergency expense.
Here is a step-by-step guide to help you figure out how much money you should set aside based on your individual circumstances:
step 1: calculate your monthly expenses
Start by adding up all your monthly expenses, including rent or mortgage, utilities, groceries, transportation, insurance, and any other regular bills. See my past article on Budgeting Basics for a free template that makes it easy to identify and track your expenses.
As you are calculating your monthly expenses, you will want to differentiate between necessary expenses and discretionary expenses. Necessary expenses are basic expenses that you cannot avoid, whereas discretionary expenses are those that you could cut back if needed.
step 2: determine your runway
Your runway is the length of time in which you want to be able to rely on savings to support you in the case of no income. Financial experts often recommend having at least three to six months worth of living expenses in your emergency fund. To determine whether you should be on the low- or high-end of that range, consider your personal risk tolerance and job stability. Are you in a high-demand field, or is your job more susceptive to economic downturns? Do you have a side gig that provides you with steady income? Allow the answers to these questions to inform your target savings.
step 3: gradually build your fund
It can be overwhelming to save several months’ worth of expenses all at once. Start by setting a realistic monthly savings goal that you can consistently achieve. Over time, you may find yourself needing to adjust your fund. For example, if you get married, have children, buy a new home, or experience a change in income or expenses, it will be a good idea to revisit your calculations and set a new target.
where should I keep My fund?
According to the Consumer Financial Protection Bureau, you want to make sure that your fund is stored in a place that is safe, accessible, and where you will not be tempted to spend the fund on non-emergencies.
The best option, in my opinion, is a separate bank account. Bank accounts are one of the safest places to put your money because the government insures the first $250,000 as long as the funds are in a FDIC-insured bank.
You may be tempted to invest your emergency fund in order to gain earnings. Experts are divided on this topic because you don’t want your funds to be tied up in the case of an emergency. Hence, if you decide to invest the money in your emergency fund, I recommend placing it in a high-yield savings account, which allows you to easily access your savings.
Emergency funds are the cornerstone of sound financial planning. They offer protection, peace of mind, and financial security when life throws you a curveball. By following the steps outlined in the article, you can determine how much you need to save and create a financial safety net that helps you navigate unexpected expenses with confidence.