Nearly 40% of Americans wouldn’t be able to cover a $400 emergency without going into debt. An emergency fund helps by giving a safety net to fall on when the unexpected happens.
An emergency fund is a financial safety net you can rely on if a major unexpected event happens in your life. At the same time, it can help you earn interest and reach your financial goals. Unlike rainy day funds that aren’t meant for smaller, one-off expenses, an emergency fund is there to help in significant times of crisis. People commonly use emergency funds for:
- Job loss
- Major illness or injury
- Major home repairs caused by natural disasters, water leaks, mold, etc.
When should I use my emergency savings?
Emergency funds should be used for major emergencies and not for expenses you forgot to plan for, like birthday gifts, car tag renewals, property taxes, etc.
If you can answer “yes” to these two questions, it’s most likely an emergency.
- Is this an urgent expense?
- Is it unexpected?
Here’s a step-by-step guide on how to start an emergency fund.
- Create a budget. You won’t know how much you’ll need to save each month for your emergency fund until you know how much you spend each month. That starts with creating a budget.
- Decide how much to save. If you’re just starting your emergency fund, set a smaller goal of $500 or $1,000. Once you get there, you can set a higher goal of three to six months’ of expenses, depending on your needs.
- Decide where you’ll keep your money. There are six types of accounts you can use for your emergency fund. Start out with a high-yield savings account from a digital or online bank first, then decide if you’d like to move some of your savings into a CD or Roth IRA once you’ve saved a nice buffer. Just note that you won’t want to move all your funds into a CD or Roth IRA, as you may pay a penalty when you try to access your money for emergencies. Keep all or most of your emergency fund in an accessible place.
- Automate your savings. Set your bank accounts up so that part of your paycheck goes to your emergency fund each time you get paid. For example, digital banks like Chime let you automatically round up your debit card purchases to the nearest dollar and deposit the difference to your bank account. Other banks may let you transfer a percentage of your paycheck straight to savings. If money is tight, start with a small amount like 5%, then work your way up. No amount is too small to start saving.
- Sock away unexpected money. Boost your emergency fund by saving any extra money you receive throughout the year, such as birthday or holiday money, work bonuses, tax refunds, credit or debit card rewards and so on.
Compare popular savings accounts by APY, minimum deposit and fees to find the right one for your emergency savings fund.
Most experts recommend keeping three to six months of basic expenses in your emergency fund. But this is a general rule of thumb. The most important thing is to save what you can — whether that’s $50 or $500 a month.
There’s no one-size-fits-all when it comes to calculating your emergency fund. Here are three possible methods to determine how much you need to tuck away for a rainy day.
- Base method. With this method, you’d need to put away $500 to $1,000 for a few of the most common unexpected expenses like care repairs and medical expenses.
- Monthly method. Estimate your daily living expenses for one month. Multiply that amount by three or six months to have a nice cushion in your emergency fund. If your income is unstable, consider saving enough to cover expenses for six months or more.
- Dave Ramsey’s emergency fund. Dave Ramsey, a finance radio show host and author, combines the base and monthly method. He recommends starting with $1,000 in your emergency fund until you’ve paid off all of your consumer debt. Then, beef up your fund by saving three to six months’ worth of expenses.
Example: Emergency fund monthly method calculation
Here’s how much you might put away using the monthly method after breaking down your monthly expenses:
|Cell phone bill||$75|
If your goal is to have three months’ worth of expenses stored away, you’d need $7,620 ($2,540 x 3) in your emergency fund. For a more conservative savings plan of six months, you’d need $15,240 ($2,540 x 6).
If money is tight, it might be hard to find some extra cash to support your emergency fund. Instead, focus on what you can save, rather than what you should save. Here are a 4 tips to try to expedite your savings goals:
- Evaluate your monthly budget. Take a hard look at your spending and see if there are any areas that you can slim down on your budget. Reallocate those funds toward savings.
- Try different savings strategies. Experiment with different savings challenges to find a technique that works for you. For example, the $5 savings trick is to pay for everything in cash and stash away any $5 that you get back in change. Or try the penny challenge, which means you save a penny a day, two pennies on day two, three pennies on day three and so on. By the end of the year, you should have put away $667.95.
- Use a rewards card. Opt for a credit or debit card that pays you back for everyday spending. And some cards can help jumpstart your savings with generous signup bonuses.
- Open an interest-bearing account. A high-yield checking or savings account rewards you for saving. The more you have in your bank account, the more interest you’ll accumulate.
Pros and cons of an emergency fund
Having an emergency fund comes with a host of benefits, but there are also a few caveats to keep in mind.
- Gives you a safety net. An emergency fund reduces your chances of having to take on more debt when an unexpected expense pops up.
- Reduces stress. Have peace of mind knowing you have money waiting if you lose your job, develop a serious illness or need to make major home or auto repairs.
- Helps your credit score. An emergency fund doesn’t directly improve your credit. But it does help you avoid maxing out on credit cards and worrying about missing payments if hard times hit — two factors that can lower your score.
- Takes time to build. It could take months or years to build up your emergency fund. You can speed up the process by saving unexpected money and using a budget to reduce expenses. If you need money now, consider an emergency loan as a last resort.
- Potential withdrawal limits. You can typically only make six withdrawals a month from a savings account. There may also be limits on how much money you can withdraw at one time. For example, Bank of America only lets you transfer out $1,000 a day.
- Doesn’t work for all account types. Avoid keeping your emergency fund in a CD where you’ll get penalized for accessing it early. Instead, opt for a high-yield savings account from a digital or online bank where you’ll have easier access to it.
Emergency funds can help you add a buffer between you and the unknown. How much you should save depends on your financial situation and goals. As always, compare savings accounts to find one that’s best for your emergency savings.