The Ultimate Beginner's Guide to Emergency Funds

Dealing with an emergency – whether it is a family member getting sick, your car breaking down, or getting laid off from your job – is stressful enough. These emergencies get even worse when you don’t have enough money to get you through a difficult time.

Unfortunately, anything can happen, no matter how carefully you plan. This is where saving an emergency fund comes in. Having emergency money saved for the unexpected can save you from financial ruin and provide peace of mind.

Despite the common advice to put money aside for emergencies, only 39% of Americans have enough savings to cover a $1,000 emergency. That is a particularly troubling number when you consider that the recommended emergency fund size is at least 3 months of basic living expenses. If 61% of Americans don’t even have $1,000 accessible for emergencies, they certainly don’t have several thousand dollars necessary to cover their fundamental expenses for several months.

If you don’t have an emergency fund, this article will answer all of the questions you have so you can start saving today.

1. What is an emergency fund?

Table of Contents

An emergency fund is a pot of accessible money that is put aside in case a costly accident or any financial surprises come your way. This means that this money should not be tied up elsewhere, such as investment accounts or Certificates of Deposit (CDs). The money should be cash safely kept at home or “cash” in a bank account that can be withdrawn anytime without a waiting period.

This money should only be spent on emergencies and not on monthly expenses or discretionary purchases. If it gets too tempting to spend your emergency fund, you should start separate savings accounts for “needs” (monthly expenses) and “wants” (discretionary purchases) so you’ll leave your emergency fund alone.

Bottom Line: An emergency fund is an important part of your financial plan that will assist you in case of an expensive, urgent emergency.

2. Should I start building my emergency fund now?

If you think an emergency fund is not the most intuitive thing to do right now, especially if you’re living paycheck to paycheck or if you have a lot of debt, you’re not alone. Most people think they’ll have trouble saving money to build an emergency fund, so they put it off and it never happens.

The moment cash starts flowing into your bank account it can be very tempting to just spend it. You may even wonder if you should be paying your student loan first or investing it somewhere it can work for you. However, saving an emergency fund is one of the first steps you should take, before paying off debt or investing.

Why? Because it will keep you from getting in more debt if an emergency arises. Please note that you do not have to have your entire emergency fund saved before you start paying off your debt. Commonly, it is recommended that you save a $1,000 “baby” emergency fund and then focus on your debts. Once you have reduced your debts and therefore opened up more cashflow (because you have fewer minimum payments), you should continue saving your full emergency fund. Only after the emergency fund is saved should you start investing.

Not convinced? In addition to financial stability, there are other benefits you get from having an emergency fund:

Peace of Mind: It will give you peace of mind that your future self will thank you for. When life presents an emergency or your financial well-being is threatened, you will find yourself much more confident and less stressed with an emergency fund to back you up. An emergency fund will give you the confidence of knowing that you can tackle any life’s unexpected events without adding financial problems to your list of things to worry about.
Prevents Financial Downward Spiral: An emergency fund keeps you from making bad financial decisions. For example, you might consider accruing debt (and there’s no such thing as good debt) to cover an emergency. But you won’t have to resort to credit cards or loans if you have an emergency fund saved.

Bottom Line: Yes, you should start right now. Save a $1,000 emergency fund, then focus on paying down debt. When your debt is manageable and you’ve freed up some cash flow, continue saving your full emergency fund while paying off debt. Finally, once the entire emergency fund is saved, start investing.

3. How much should I save?

To calculate how much money you should have as your emergency fund, you need to begin by taking a look at your monthly fixed costs for your necessary expenses, which include:

Housing expenses – You need to include monthly rent, property taxes, mortgage payment, etc. in your monthly calculation.
Food – You should also consider the amount of money you are spending on food every month.
Transportation – Add in what it costs you to get to work. In most emergencies, you will still need transport to work, or you will have even more financial stress.
Utilities – Take into consideration the average amount you are spending every month on utilities. This might include electric, water, gas, and other bills like internet (no, Netflix and cable don’t count!).
Insurance – Take a look at the total cost of your life, medical, dental, disability insurance, etc. If you lose your job, you should be able to pay for these until you can find a new job.
Debt – Factor in student loans, credit cards, or any other personal loans you may have. When an emergency arises, the last thing you want is your credit score taking a hit if you aren’t able to pay the minimum each month.

The rule of the thumb is that your emergency fund should consist of at least three months of your living expenses. For instance, if you are paying $3,000 every month to cover your basic needs, then you should set aside a minimum of $9,000 in your emergency fund.

However, if there are family members dependent on you, then your emergency fund should be at least six months of your living expenses. If you are conservative and want to be extra safe, you can keep as much money in your emergency fund as you need to feel safe. This can be up to 12 months of living expenses or even more.

Bottom Line: Save three to six months of basic living expenses, depending on your personal situation.

4. What if I can’t save that much?

Start Small

That’s fine, you can start small. For instance, you can start by saving as little as $85 every month, this will add up to your “baby” emergency fund of $1,000 over the course of a year.

However, that is the bare minimum. Do your best to save up for at least a month’s worth of expenses, which for most people is a couple thousand dollars. Make it a goal to have a month’s worth of expenses saved 12 months from now. Then you can move on with two months, and so forth.

Automate

Start by making saving a priority through automatic paycheck deductions into a savings account that is specifically earmarked as your emergency fund. It is important that the emergency fund is saved in a distinct location so it is not spent on anything besides emergencies!

Prioritize

You can also try treating your emergency fund as one of your fixed-cost bills. Take depositing your savings each month as seriously as paying your electric bill. Remember, saving an emergency fund should be one of your highest personal finance priorities. This might mean that you cut out some unnecessary spending in order to be able to contribute to your emergency fund for a year.

Earn More

Additionally, you can take a temporary side-job in order to earn extra money. Then, have every paycheck from that job funnel into your emergency fund. You can quit the job once you’ve saved an amount equal to your three or six month expenses. If you took a side-job that paid $15 per hour and you worked 20 extra hours a week, it would take you about 9 months to save a $9,000 emergency fund (considering taxes). If you sold stuff you owned or provided a skilled service at a higher rate, you could save this money even faster!

Bottom Line: It’s okay to start small, just be sure to start. Automate your savings to a specific emergency fund account, prioritize this saving, and find ways to earn extra money to save.

Related Reading:

5. Where should I keep my emergency fund?

Although it’s good to keep your emergency fund in a place where it’s easily accessible, it may not be the best idea to keep all of it in cash at home. If you want a portion of it in cash for emergencies, put it in a fireproof safe.

You should keep your emergency fund anywhere that doesn’t tempt you to withdraw or spend it, and is also easily accessible.

One place that meets both of these criteria, easy accessibility without the temptation to spend, is a savings account that is linked to a checking account. Often, you can’t withdraw money directly from a savings account, you have to first transfer it to a checking account. Make sure the savings account and checking account are at the same bank, as this will mean same day, if not instantaneous, transfers.

Having the transfer as a barrier to easy withdrawal makes you stop and think “Is this really an emergency?” But having the same day transfers ensures that you can quickly access the money at a moment’s notice in the case of emergency.

Online Savings Accounts

It may be best to save this money in an online savings account. Online savings account providers, such as Ally Bank, don’t have physical bank locations. Because of this reduced overhead cost (they don’t have to pay for tellers or rent or electricity), they can offer much higher interest rates on savings accounts. Sometimes, the interest rates can be up to 40 times higher at online banks (2%) compared to your standard neighborhood bank (0.05%). Since your emergency fund should be (for the most part) just sitting in the savings account, it makes sense for it to be earning you extra money while it’s there!

But if there are no physical bank locations, you might ask, how do I access my money? Actually, this makes it easier to access your money in most cases, since most online banks will allow you to withdraw funds using your debit card at any ATM, and they will refund any ATM fees. That’s more flexible than having to find an ATM or bank location of one certain brand!

Earning Interest

Earning interest is another concern some people have when considering where to keep their emergency funds. They want to make sure that they are earning money on their savings, so they want to keep it in an investment account or a Certificate of Deposit (CD) in order to gain higher interest rates.

Investment accounts are a poor place to keep emergency funds because there is a chance you could lose a significant portion, or all, of the saved money depending on the market. Additionally, there is a waiting period to withdraw the money, and you may not have that time during an emergency.

Similarly, you don’t want to keep your emergency fund in a CD because you receive a higher interest rate in return for keeping your money in the CD for a predetermined amount of time. This limits the accessibility of your emergency fund, which could make it useless in a time of emergency.

Bottom Line: Keep your emergency fund in an online savings account that is connected to a checking account. If you want, keep a portion of the emergency fund in cash at home, in a fireproof safe.

6. How can I determine when to tap into my emergency fund?

While experts are very clear as to how much you should set aside for an emergency fund, they are not always so clear on when it is appropriate to spend this money. Here is a list of expenses that could be considered legitimate emergency costs:

Unexpected medical costs – A medical crisis, along with the hospital bills that come with it, is one of the most legitimate situations in which you would use your emergency fund. Of course, you want to make sure you use your insurance if possible, and/or reimburse your expenses from a health savings account or flexible spending account if you have one.
Expenses after losing your job – Without an income, of course, you may have no choice but to draw from your emergency fund. If you can’t find temporary employment or full-time employment quickly, you will still need to pay your bills, and that’s what the fund is for. Be sure to immediately cut out any unnecessary expenses to make sure your emergency fund can last as long as possible. Also, make sure to replenish the fund once your period of unemployment comes to an end, and take what you learned about how much you had saved to adjust the amount in it if need be.
Urgent car or home repairs – If your water heater burst or your car’s engine died, you won’t have any choice but to pay for emergency repairs.

Bottom Line: If something is a want instead of a need, it definitely is not an appropriate reason to tap your emergency fund. Only use this money in true emergencies, when you have no other option and cannot wait until you have earned more money to spend.

Expect the Unexpected

Life is indeed full of surprises. There are a lot of things that can catch you off guard, such as an emergency car repair or getting laid off from your job. Without an emergency fund, these unwanted and unexpected circumstances could leave you financially stranded.

Wouldn’t it be great to have a stash of cash waiting to be accessed when the unexpected happens? Saving the right amount of money can keep an emergency from wrecking your overall financial situation.

Emergency Funds are Also Opportunity Funds

Opportunity comes in having flexibility and “room to breathe” when a financial disaster hits. Instead of responding to an emergency haphazardly, with poor financial decisions, you can step back and make a better choice because you have the freedom provided by a cash cushion.

Imagine being laid off just as you were considering starting your own business. You could live off of your emergency fund while you got that business off the ground, instead of jumping to accept the first job offer (even a bad one) as soon as you got it.

Financial peace of mind and flexibility are just two of the major benefits of saving an emergency fund.