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Emergency fund: What you need to know to build one

At a glance:

  • What is an emergency fund?

  • Where to keep your emergency fund

  • Finding money to save for an emergency fund

  • Summary of building an emergency fund

  • Practical idea you can start with today

Life throws lots of surprises at you, many of them financial: the refrigerator dies, the radiator on the car goes out, we get a surprise tax bill, or a job is terminated.

If you lack an emergency fund there are other options, including credit cards, payday loans, pawnshop loans or loans from family members or friends. Each of these options have their own problems: high interest rates, making them difficult to pay back, as well as potential conflict with people close to you.

It's at that point, when you hit a financial bottom, when you realize the importance of setting aside a certain amount of cash for unforeseen occurrences.

Doing so can buy you peace of mind while sacrificing spending for the short term.

Ideally, you want to have this cash saved up sooner rather than later so that you don't suffer a major inconvenience when something does go wrong.

What is an emergency fund?

An emergency fund is an account set aside to gather money for emergency use. The emergency itself may be anything, but it's wise to plan for the worst, which means loss of your ability to earn income. Conventional wisdom says to save for three to six months' worth of your daily expenses, though others suggest more, especially during periods of economic uncertainty.

This includes rent, mortgage, major bills, food, etc. Paradoxically, you tend to need an emergency fund the most when you're not financially stable, like when you're just starting out, which is when it is the most difficult to save. Emergency funds are something that you can't create overnight. It can take a year or more to build a fund sufficient to meet your minimum emergency needs and years to build up a more robust amount of savings. Some people add to them over the course of years instead.

Use existing money if you can

Ideally, you want to pay for emergency expenses with existing funds. Though credit will do the job as well as cash in your savings account, it comes with expensive strings attached. Interest on credit cards, just like the interest on savings accounts, adds up over the months, so you end up paying off a bill higher than what you originally incurred. In addition, credit card companies may levy extra fees or higher rates if you go over your limit or forget to pay your bill, adding to the overall cost. An additional advantage of using existing money is that it can earn interest or dividends if sitting in an account in a financial institution.

First, track your expenses

You should know your spending and earning habits well enough to decide how large of an emergency fund you're going to need. If your income is not stable—which is true for many self-employed consumers—you may need a larger fund than someone who gets a steady paycheck does.

Begin by determining how much money you spend in a month, including housing-related expenses, utilities, car payments, gas, insurance, food, and loan payments. Since a loss of income-earning ability will mean cutting out unnecessary expenses during that time, focus on the necessary ones.

Once you have your total dollar amount, multiply it by the number of months you think you'll need.

With this goal in mind, determine a safe amount to sock away each month or week. At first, it's probably best to set aside a small amount, but be consistent with it.

Start small

Don't be discouraged if the amount you need to save seems impossibly large. With the help of budgeting and automatic savings plans, you can begin saving a small amount. It's beneficial to even have one month of expenses in an emergency fund versus nothing. And as you get pay increases, tax refunds or cash gifts, you can sock away more, increasing the size of the fund over time.

Where to keep your emergency fund

In the old days, people would talk about keeping their money under the mattress at home. But that was before deposit insurance and credit union share insurance were created to protect accounts at financial institutions. Now you can stash your cash there and earn interest or dividends on it, and keep it away from mice, too.

Liquidity is ideal

Ideally, you want to store your emergency cushion in a liquid, easily accessible account that does not lose its value, so you know how much money you have available in the event of an emergency and you can withdraw money quickly. Savings accounts offer excellent liquidity. So do money market accounts. Though they hold their value, certificates of deposit and savings bonds are not very liquid, though you can take your money out prematurely; however, you will likely be penalized for early withdrawals and lose some of the earnings you've built up.

What is not ideal

Not all accounts are suitable for emergency funds. Retirement accounts, for example, should stay put so they can have growth potential over the course of decades. Taking money out prematurely can cost you a huge amount of growth and early withdrawal penalties and taxes over the long term. Tapping a revolving credit account, such as credit cards, can end up costing you much more in finance charges than you need to cover your emergency expense.

Some people choose stocks or other market-based investments for their emergency funds due to those investments' potential to grow in value over time. While this can indeed happen, remember that the volatility of the market may put you at a disadvantage when it's time to take your money out. You may end up with less than you put in.

Special accounts for an emergency fund

Many credit unions and banks now offer certificates or savings accounts for specially designated purposes, such as emergency funds. Having an account specially tailored for an emergency can be a psychological boost that motivates saving. If your institution does not offer one of these types of accounts, there are still many choices that you can use for this purpose anyway.

Finding money to save for an emergency fund

One of the biggest objections to starting up an emergency fund is "I don't have enough to set aside for one." But often, you do. Spend a month tracking every cent, and you will probably see where money is slipping through the cracks. Are there any services or expenses you could do without or cut back on? Are you expecting a big tax refund soon?

Some ideas

Doing a Web search on emergency funds can bring up some surprising tips for finding spare cash. Some are harsh and draconian. Others are well thought out and recommended by financial advisors. Here are some of the more common suggestions:

  • Treat it as a bill. Add your emergency fund to your regular bills; this will give it a sense of priority. If you need to start small, such as $10 per month, that's still a good start.

  • Unnecessary expenses. Take stock of all the goods and services that you use that are not strictly necessary, such as services you could perform yourself, spur-of-the-moment spending choices, or excessive insurance coverage. After you've cut them out, you might try staying in that mindset, but instead putting the money that you would have spent on them into your emergency fund.

  • Loose change. Put all loose change into a special jar just for your emergency fund.

  • Bonuses or raises at work. If you get a bonus or raise, put all or most of it into your fund.

  • Cash gifts. If you get a cash gift for your birthday, a holiday or another special occasion, you can add it to your emergency fund.

  • Tax refunds. Due to their size, these are the most likely source of funds and are a good way to begin an emergency fund.

  • Adjusting your income tax withholding. If your yearly tax refund is typically quite large, you can adjust your tax withholding so that less is withheld each month; put that difference into your fund so it builds up earnings.

  • An automatic savings account. You can set up automatic transfers of money on a periodic basis from one account to another. An advantage of this is that it can save you the time and energy otherwise needed to locate money to save. Just be sure you have adequate funds in your source account to cover the transfer.

  • Investment earnings. If you've got stocks, bonds or mutual funds that pay regular income, you can divert that into your emergency stash for a while.

Once you have your fund in place at a financial institution, you can start accumulating earnings on it.

Summary of building an emergency fund

Once you've got your emergency fund fully funded, you can breathe more easily. Maybe you can start up your cable subscription again, or drink a few more lattes each week. Building a cash cushion is an exercise in discipline that you might have to repeat again years later if you need to meet unexpected expenses.

Now that you understand what an emergency fund is, we'd like you to think about setting one up if you haven't already.

Practical idea you can start with today

  • Create an emergency fund of 3 to 6 months' living expenses.

This content was created in partnership with the Financial Fitness Group, a leading e-learning provider of FINRA compliant financial wellness solutions that help improve financial literacy.

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