Emergency Fund Definition – How to Get Started
The term “emergency fund” refers to a savings account that can be accessed in the event that unforeseen expenses or expensive financial surprises occur. If you have a healthy emergency fund, you will be able to handle a difficult situation without resorting to taking out a loan or borrowing funds from loved ones or friends.
Utilizing the funds in your emergency fund, as opposed to taking it out of your bank or savings account, is something that should only be done in extreme cases of financial hardship. The following information below is an explanation of what an emergency fund is as well as instructions on how to build one.
What Is an Emergency Fund?
At any moment, you can find yourself in need of to cover an unforeseen price. Either your vehicle could suffer a breakdown that calls for a replacement transmission, or you could end up needing pricey medical treatment.
That is why it is important to have an emergency fund. You should always have some funds set aside in case of sudden expenses or unexpected events, and you should do so in the form of an emergency fund.
You should keep your savings for unforeseen expenses in a different bank account from the accounts you utilize for your daily financial activities. You should only access this savings account in the event that you are unable to quickly pay for an unforeseen expense.
It’s a preventative measure you may do to prepare yourself for very little anxiety and more safety regarding your finances.
Why Do You Need an Emergency Fund?
The ability to save funds in case of an emergency is similar to having some kind of self-funded insurance coverage. By putting funds aside for retirement, you’re essentially paying yourself rather than an insurance company.
For instance, if you have enough funds saved up, you won’t have to worry about how you’re going to pay for your essentials in the event that you get fired from your work before you can find another source of consistent income.
Or, if you anticipate that your vehicle will rack up a lot of miles, having an emergency fund allows you to be better prepared for the likelihood that it will experience mechanical problems in the future.
If you do not have family members who live nearby and are able to assist you in a time of need, it is extremely crucial to maintain a savings account designated specifically for emergencies. You won’t have to worry about getting short on cash because you know it will be available for you in the event that you require it immediately.
How to Build an Emergency Fund
In most cases, the most effective strategy for accumulating an emergency fund is to set up an automatic transfer of a predetermined amount of funds from each paycheck into an emergency savings account. However, this may be difficult if your income is unpredictable or your budget is little, in which case you may need to adjust the procedures below accordingly.
The following are the fundamental actions you should take to build up your emergency fund:
- Make a Plan of Action. Make a decision regarding how much funds you would like to keep in your emergency reserve. If you are starting your emergency fund from the beginning, you should aim for a target that is more reachable than overwhelming at the outset, such as $2,000.
You can also start your savings journey by calculating your monthly spending and setting a goal to save the equivalent of one or two months’ worth of costs. As soon as you reach that benchmark, you should move on to establishing new objectives so that you can continue to increase your savings until they reach a level that is comfortable for you.
- Get Financially Organized. After deciding what you want to achieve, the next step is to establish a strategy for how you want to get there. The creation of a savings budget is an essential step toward reaching your goal.
You have the option of putting together a budget right now if you do not already have one that you are able to follow and that places a high priority on achieving your savings objective.
- Seek Out Money. When making your budget, if you discover that you don’t possess many funds left over to put into your emergency fund, you should look for places where you may cut back on your expenditures.
You can save costs by canceling subscriptions that are no longer required or a gym membership that is not being utilized, preparing more meals at home, and haggling with your utility providers. You might also think about beginning a side business or selling things that you no longer need.
Last but not least, you can speed up the growth of your emergency fund by putting windfalls into savings. Put any funds that come your way unexpectedly, like funds from a birthday gift or a tax refund, or funds from any other source, into an emergency fund.
- Establish Programmable Deductions For Your Savings. You should arrange for a transfer of funds from your checking account to the account you keep for unexpected expenses to be made automatically on a recurring basis. This should take place each time you get paid. With this method, you may ensure that you won’t forget to make contributions to your emergency fund.
Your bank should be able to facilitate the setting up of automated transfer procedures. In addition, some employers provide their employees with access to savings accounts for unexpected expenses, which makes it easy to have necessary funds automatically deducted from your account.
- Evaluate How Far You’ve Come. Check the balance of your savings account on a regular basis, such as after each paycheck, to confirm that your deposits are correct and to acknowledge your progress.
If at all possible, only withdraw funds from your savings in an actual emergency. If you end up having to use your savings for an emergency, you should formulate a strategy for how you will get those funds back once the situation has been resolved.
Where Should You Keep Your Emergency Fund?
Maintain a second bank account for your savings for unexpected events in addition to the account you use for your day-to-day banking. If you store your savings in a checking account, you run the risk of being tempted to use the funds for non-urgent expenses, such as purchasing a new television or going out to a lavish dinner.
Because you never know when you might need it, it’s important to maintain your emergency funds in a place where it’s easy to get to in case of a sudden need. The following are some possibilities for your consideration.
- Interest-Bearing Bank Accounts. It’s ideal to maintain your emergency fund in a high-interest savings account from which you may withdraw funds quickly in an emergency. You can’t go wrong with these choices:
- High-yield savings account. You can earn more interest on your funds for unexpected expenses by opening a high-yield savings account. Your options include traditional banks, online banks, and credit unions if you want to open an account.
- Money market account. The interest rate on a funds market account is typically higher than the rate offered on a regular savings account, and these accounts can be opened at most banks and credit unions.
High-interest checking accounts are similar to high-yield savings accounts, except that they often allow you to write checks and may have higher opening and minimum balance requirements.
- Short-Term Investments. Short-term investments are a popular choice for some people who want to set aside funds for emergencies but don’t want to tie up too much of their savings in cash.
You should exercise caution before putting your emergency fund in illiquid investments like Treasury securities or certificates of deposit (CDs), which offer a fractionally higher interest rate than a savings account.
If you suddenly require access to your funds, you may be subject to early withdrawal fees. Since you can’t know when you’ll have an emergency, bond laddering can only help you structure some of the liquidity in your strategy; the rest is still at risk.
Keep all or most of your savings in a liquid account, and come up with a different strategy for investing the rest of your funds that you won’t need right away.
How Much Should You Put Into an Emergency Fund?
The quantity of funds you need in your emergency fund as well as how much funds you should set aside relies on a number of things, including your present income and the kinds of costs you have on a regular basis.
The majority of financial advisors advise their clients to set aside an emergency fund with enough funds to cover their needs for three to six months on average. If, on the other hand, your employment title is anything like “freelancer” or “gig worker,” or if you get paid on a commission basis, you should probably put aside even more funds.
You may determine how much funds you require for an emergency fund, also known as the exact amount that you need, by looking at how much funds you spend each month on essential costs like your rent, your utilities, and your food. When you’ve finished tallying up your monthly costs, simply multiply that number by three to six months.
There are some individuals who make the decision to put away three to six months’ worth of income rather than three to six months’ worth of costs. This is a particularly difficult goal, but achieving it could provide an additional cushion in the event of more serious disruptions.
Consequently, if your typical monthly income is $4,000, you will need to set aside $12,000 in order to cover an unexpected expense for three months.
It is ultimately up to you to determine how much funds you should have stashed away in an emergency fund, taking into account how much funds you require for your basic requirements.
In What Situations Should You Use Your Emergency Fund?
It is possible for a sudden expense to give the impression of an emergency, even when this may not be the case. If you are unsure whether or not you will need to use your funds for an emergency, you can determine this by asking yourself the following three questions:
- Does it come as a surprise?
- Is there a need for it?
- Is it urgent?
The more questions to which you respond “yes,” the greater the likelihood that the scenario you find yourself in qualifies as an emergency and warrants withdrawing funds from your savings for unexpected events.
Bottom Line
Having an emergency fund can help you feel more financially secure and reduce your dependency on debt at the same time. In addition, knowing you have enough funds set aside to weather any emergency can bring a great sense of calm.
Having an emergency fund is a stellar way to feel more in control of your monetary situation, but setting savings goals and automating your savings is an even more powerful method to enhance your financial life.
The same strategy that helped you build a solid emergency fund can be used to achieve other savings goals, like a home down payment.
