You’ve probably heard how it’s important to have an emergency savings fund, but what does that actually mean? How is this type of fund defined, how much money should you have in it, and what expenses should it cover? How can you make creating this fund a financial priority?
Here, we’ll cover that and more, starting with an emergency savings definition. This fund is one where you’ll set aside money in case you’re hit with unanticipated expenses, rather than for ongoing monthly bills, such as your mortgage payment or rent. Emergency expenses could include medical bills, furnace or air conditioning repairs, or car repair expenses.
Funds can also come in quite handy if someone in your household loses their job, or has hours at work slashed back. Because these funds are earmarked for unforeseen emergencies, it’s important this money is readily accessible, so you can withdraw funds quickly without a financial penalty.
Now, we’ll dive into how to start an emergency savings fund, how to determine the amount of savings that’s right for your unique financial situation, one way to save emergency funds, and more.
Starting Your Emergency Savings Fund
Imagine that you’ve been hit with a car repair of $500, or $1,000, that you didn’t expect. Would you easily be able to pay that amount out of savings, or would you need to rely upon a high interest credit card?
If the latter, then try to imagine how you’ll feel once you’re able to pay for emergency expenses out of an account created for that purpose. Simply acknowledging this can increase your personal commitment towards opening and building this account.
What’s most important is getting started, so start small and, whenever you’re able, add to your emergency account. If you focus too significantly on how much emergency savings you’ll ultimately need, it might feel overwhelming. Instead, just start small. Just start.
Then, take a look at your budget to see how much money you can have automatically transferred into this account each month. If, say, you get a check for your birthday, decide how much of that should go towards building this account.
One interesting test you can try is to determine how much money you’d get if you filed for unemployment in your state. Then, live on that amount of money for a week to get a sense of how you’d need to live if you suddenly lost your job and didn’t have emergency savings. This exercise will provide insight into why prioritizing this savings account is crucial.
How Much Emergency Savings Should I Have?
In general, many suggest that you save three to six months’ worth of your expenses, which means that the actual dollar amount depends upon your unique financial situation. So, add up what you pay in monthly housing expenses (mortgage or rent, utilities, taxes, insurance, and so forth), plus for car payments, insurance, gas and so on. What about credit card bills? Student loan expenses? Healthcare? Cell phones?
After you come up with your total, then multiply it by three months, plus four, five, and six months. This gives you a range of how much you should save for a rainy day.
As another step, add up your take-home pay (after taxes) and subtract all of your monthly expenses from that amount. How much is left? How much of that amount could go into your rainy day fund?
What expenses could you cut back on to increase that amount? When, for example, was the last time you got quotes for your car insurance? What expenses could you actually eliminate, perhaps an app or subscription that you haven’t used in quite a while?
Now, how much more money could go into your emergency savings account?
Here’s another way to look at how much emergency savings makes sense for you. You’ll want to have enough so that, when unexpected expenses crop up, you won’t be forced to use costly options, such as credit cards, payday loans, home equity lines of credit (HELOCs), 401(k) loans and so forth.
You also, though, don’t want to have too much money in your emergency savings fund. Why? Because this type of fund should be liquid, it likely won’t pay a large amount in interest. So, once you have enough money in a rainy day fund to cover emergencies, find more lucrative ways to invest excess funds.
Before we move on to another topic, here’s another way to look at how much emergency savings makes sense for you:
• If you have bad debt, have at least one month’s worth of expenses saved
• If you don’t have bad debt and you are in a dual-income house, then have three months’ worth of expenses saved
• If you don’t have bad debt and are in a single-income home, save six months’ worth
More About the Benefits
The goal of your rainy day fund is to give you the ability to cover unanticipated, urgent financial issues without having to disrupt your ability to cover your normal living expenses. And that, all by itself, highlights the importance of creating this fund.
Here are two more important benefits. One, this gives you the freedom to switch jobs without adding financial stress, whether you’re switching because you were downsized or left by choice.
Thoughts on Investing
Because emergency savings are designed to be there for you, no matter when you need the money, liquidity is important, so it doesn’t make sense to put the funds in an account that, say, has a one-year term with penalties for early withdrawals.
And, when it’s time to tap into your emergency savings, you surely don’t want to find out that its value has been reduced because you’ve invested in funds with volatility and recent poor performance.
Even if you invest conservatively, there will still be market fluctuations and it’s possible that you’ll need funds at a time when values are lower—and that’s one reason why investing emergency savings in the stock market is especially challenging.
Here’s another reason why it may not make sense to invest emergency savings in the stock market. One key reason why people tap into emergency savings is because of job loss.
And, when the economy is down, more people typically get laid off from work and the stock market is usually more volatile. So, this means you might need to use your emergency savings most urgently when the value is at its lowest.
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