You probably already know that you should have an emergency fund—a bit of extra cash on hand in case of an unforeseen event, like getting laid off or needing to move.
But many of us don’t know more than that. How much should you have? How, exactly, do you save that cash? And should you focus on building this fund or paying off debt first?
SoFi advisor and Certified Financial Planner Alison Norris recently talked about all of this and more at a recent #WealthWednesday discussion on the SoFi Member Facebook page. (Yep, SoFi members have daily access to complimentary advisors on social media and via phone—check out more about the SoFi Member Benefits.)
And today, we’re bringing that discussion, as well as other common questions about emergency funds and her expert answers, to you.
How much should I have in an emergency fund?
Your emergency fund should be three to 12 times the amount you spend monthly. The exact amount should reflect your risk aversion to unexpected unemployment. If you have reason to believe you could quickly land another job—say, you’re a software engineer in San Francisco—then you might be comfortable with three months’.
If, on the other hand, you’d expect a longer job search—for example, you’re in a specialized line of work, or a finding a new job would likely entail moving to a new city—your emergency fund should reflect that
Also, consider this: Would you be willing to amend your lifestyle if income slows or something costly crops up? If you’re OK living on a friend’s couch eating ramen, then you might survive with a smaller rainy day fund. If you wish to keep living the life you’re accustomed to, then you may want more of a backup.
Where should I keep my emergency fund—my checking account, a savings account, or elsewhere?
You want to keep your emergency fund money “liquid,” or available to access as soon as you need it. It’s also smart to separate cash on hand from your emergency fund. Cash on hand can be left in your checking account, earmarked for paying upcoming bills. Your emergency fund works well in a FDIC-insured savings account.
With that said, many savings accounts only pay you 0.01% interest on cash balances. This doesn’t keep pace with inflation, so you’re essentially losing money. Instead, you might consider a high-yield savings account that earns 1.0% interest or more. Bankrate is a good place to compare your options.
What do you suggest if you have roughly $5K built up so far for an emergency fund and also about $3K in credit card debt?
Should I wipe out the debt and then build the fund back up, or chip away at the debt and maintain the fund?
I might suggest knocking out that credit card debt in full. Here’s the order of operations that works best for most:
• 1. Keep enough cash on hand to pay recurring bills and avoid living paycheck to paycheck. (This isn’t your emergency fund, just cash that’s good to have on hand.)
• 2. If your employer matches contributions to a retirement plan, max out that match.
• 3. Pay off consumer debt, including high-interest credit cards.
• 4. Build your emergency fund.
Also keep in mind that the comfort of having a cash cushion and not living on the financial edge may outweigh other purely financial benefits of wiping out high-interest debt. Sleeping soundly at night is another benefit to building up an emergency fund.
Could a credit line be considered a pseudo emergency fund?
While I don’t have credit card debt, I do have a ton of student loans I want to pay off more aggressively. My credit cards would allow me to live for a good three months or so if I needed to.
I commend your desire to pay off your student loans aggressively, but I wouldn’t do so if it means you would instead have revolving credit card debt.
Say, for example, you have a 6% rate on your student loans and a 20% rate on your credit card loans, and $1,000 in outstanding debt with both. You’ll end up paying $140 less toward your student loan each year (maybe even less because there are tax deductions for student loan interest). I might suggest prioritizing the emergency fund while making minimum payments on your student loans.
What’s the best way to save up for my emergency fund, quickly?
The basic equation for wealth building is: Money In – Money Out = Money Saved.
But you don’t need us to tell you how math works. The key is to figure out which levers to pull to increase your odds of success.
Start by tracking your expenses, either in a spreadsheet or using a free service like Mint.com. You’ll quickly get a handle on your monthly cash flows, which will enable you to target an emergency savings goal tailored to your needs.
The next step is key: Pay yourself first. Schedule recurring auto-deposits into your savings account to coincide with your paychecks. You’ll find this cash flow will quickly become painless and invisible. More importantly, it ensures that when you overspend in a given month, it’s discretionary items—like eating out one more time—that get cut, rather than your savings.
I’m almost at my savings goal for my emergency fund. Where should I put my money next?
The earlier you save for retirement, the better, so you can let the power of compounding interest work for you. And even better than compounding is free money. For both reasons, the first place to invest for retirement should be in your employer-sponsored retirement plan, if you have access to one.
Many employers will match part of your contribution, which is essentially free money. Once that match is met, aim to keep contributing to tax-advantaged accounts. You can invest in the employer retirement beyond your match, contribute to an IRA, or (our preferred strategy) both. To understand which IRA account you can contribute to, use this IRA calculator.
From there, document your assets and liabilities. Know your good debt from bad. A mortgage or student loan? Good. A high-interest credit card? Not so good. Also write down your long- and short-term goals—for example, paying for wedding, saving for a house down payment, or even taking a summer vacation.
Once you’re saving for retirement, you can plan a savings or investment strategy for these goals, based on their time horizon.
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