An emergency fund is vital when wanting to become financially free. The average American cannot even afford a $500 emergency according to VaroWorth. Learn what an emergency fund is, why you need one, how you start it, where to put it, and so much more.
What is an Emergency Fund?
An emergency fund is a pile of money that you have in a seperate account that is easily accessible. This money is only supposed to be used on true emergencies! Some people ask “What can I use my emergency fund for?”. 3 of the most common uses of the emergency fund are as follows:
- Loss of job/unemployment – If you lose your job, an emergency fund will immediately be useful. It will help you have a warm place to live, a tank of gas, and food on your table. You should start applying for new jobs as soon as you lose your job so that you don’t have to blow through your entire emergency fund.
- Major car repairs – Major car repairs suck! There is no way around it, but they are part of life. Things such as a flat tire, a cracked windshield, or a burned out engine, are just a few of the many things that could go wrong with your car.
- Unforeseen medical expenses – Medical care can be extremely expensive in America, especially when insurance doesn’t cover it. They are, again, part of life and they stink but if you have an emergency fund, they will be an inconvenience instead of an emergency.
You are probably asking something like “what questions should I ask before really deciding if this is a true emergency?”.
- Does this need to be fixed right away or can it wait?
- Is there a way to make some extra money before going to my emergency fund?
- Is this something that I could have saved up for?
These questions can help you determine if you should really use your emergency fund right now. The last question in particular, helps you prevent it in the future.
Let’s say you need new tires but never thought about it before. Since tires are a necessity and need to be fixed right away, you may have to use your emergency fund if you did not save up for them.
If you ask yourself if it is something that you could have saved for, you will realize that it is something that you will need again in the future! Start saving for new tires now so that you have money set aside for them.
This will help you keep your emergency fund in tact for when true emergencies arise.
What Is an Emergency Fund NOT?
We listed all the things that your emergency fund should be used for but let’s list a couple things that it should absolutely not be used for next.
Your emergency fund should not be used to buy a car. There is almost no reason that you should have to use your emergency fund for a new car.
Each month, you should be putting a little bit of money away towards a car. You know you will eventually have to buy one, so it is not an emergency the day that it happens.
The only exception to this rule is when the insurance company will not cover your car for some reason. Then just pull $2,000-$3,000 out of your fund and start saving to buy a better car.
It isn’t fun driving one of these cars but it will be worth it!
Your emergency fund is not for vacation. You know you want to travel so start saving for it! If vacation is going to cost you $1,000 figure out how much you need to save each month in order to afford that.
Lastly, your emergency fund should not be used for regular car work. Oil changes, tire rotations, and new tires are 3 of the many things that you have to do on a regular basis. You can start saving now so that your emergency fund doesn’t need to be touched.
How Much Should I save in my Emergency Fund?
Finance experts such as Dave Ramsey say you should have 3-6 month’s worth of expenses inside your emergency fund.
This range is going to depend on how secure your job is, how worried you are about an emergency coming, and how fast you think you can make extra money if needed.
I personally like to keep a 6 month emergency fund in a separate bank account because I like to be safe. I don’t want to be forced to take out a personal loan just to cover these expenses.
Other finance experts such as Suzie Orman say you should have up to an 8 month emergency fund. Even though it is a lot, it can’t hurt.
This would cover you for longer than Dave Ramsey’s emergency fund would, but you may be losing out on some money.
What is a Starter Emergency Fund?
If you are following Dave Ramsey’s 7 baby steps, you probably saw that baby step 1 was saving $1,000.
While I think this is a little bit low, I understand why he says $1,000. It is supposed to make you feel insecure in your finances so that you try even harder to get out of debt.
I personally think a good starter emergency fund is closer to $4,000-$5,000 because this will be enough to cover larger expenses if they come up.
Once you save that starter emergency fund, you should put all of your money on debt until you are debt free.
After you get out of debt, start saving towards your full emergency fund of 3-6 months.
What counts as a Monthly Expense?
What counts towards your monthly expenses will greatly depend on you! If you spend $300 eating out each month but you think you would be able to stop doing that for a little while if needed, then you don’t need to count that $300.
If you would prefer your lifestyle not skip a beat then I highly suggest saving that extra money.
Things such as food, mortgages, gas, utilities, and clothing are all expenses that you should be saving up for. Without being able to pay for these things, your life would be greatly affected, which is what we want to prevent.
Should I Invest My Emergency Fund?
If you are asking if you should invest your emergency fund, we can help! The answer is simply “no”. There are a few reasons you should never invest your emergency fund in mutual funds, index funds, etc.
- You would risk losing some or all of your emergency fund
- When you invest it, it is harder to get the money out of your account
Investing your emergency fund could work out, but it likely is not worth the risk. If you desperately need the money but it is tied up in an investment account, it may be really hard to get your hands on the money.
Where Should I Put My Emergency Fund?
Your emergency fund should go into a high-yield savings account such as:
- Sofi Money
These are a few of my favorite high-yield savings accounts on the market right now. While that certainly is not a comprehensive list, they are just of the options.
If you invest your money into a high-yield savings account, you will make about 1% (could be more or less depending on the market). You will not get rich off of this, but it will get you a little extra money.
There are a couple other options of where you could put your emergency fund. The first is a money market account. You can find these accounts through most banks, and they usually offer a higher rate of return than a normal savings account.
Some of the best money market accounts on the market include CaptialOne and Marcus by Goldman Sachs. There are plenty of other options out there, but these offer a little higher rate of return than the average money market account.
A CD is my last option on this list because it partially locks your money up. CDs are a type of account that offer locked in rates for a certain period of time.
They usually offer higher returns than a normal savings account, but they are about on par with high-yield savings accounts.
When you go to withdraw money from your CD, you usually have to give up all or some of the interest you earned. If you do not have enough interest earned, some banks will even take part of the money that you put in.
While the money is technically accessible, you are still paying a penalty for trying to get your hands on it.
So now you know what an emergency fund is, how much to save, and where to put it but the most important question might just be how to build an emergency fund!
How Do I Figure Out My Emergency Fund?
I will lay out a step-by-step guide to building out your emergency fund.
- Create a budget. Once you create a detailed budget, you will know exactly what you are spending your money on each month. This will help you to figure out what your monthly expenses are.
- Calculate your monthly expenses. Now that you created a budget, calculating your monthly expenses should be a breeze! Now decide how many months you want to save for. I suggest a 6 month emergency fund.
- Multiply your monthly expenses by the amount you want to save. Let’s say you have $2,000 worth of monthly expenses and you want a 6 month emergency fund. You would multiply $2,000*6. This means you need to save $12,000.
How Do I Build My Emergency Fund?
You are probably thinking OK well now I know what an emergency fund is, how much goes in it, and how to calculate it, but next you are asking how do I build my emergency fund?
- Get a 2nd Job! Getting a 2nd job is the easiest way to easily build your emergency fund. All of the income that you make at this 2nd job should go directly into this savings account. This will help you build it up very quickly.
- Keep your change. If you are using the envelope system to help you budget, then this will work perfectly. If you buy something that costs $15 and you give them a $20, put the extra $5 towards your emergency fund. This may be a much slower process compared to getting a 2nd job, but you will eventually get there. Even if you aren’t using the envelope system, round up every purchase you make! Just keep track of it and do it once per day.
- Cut Your Expenses. In my example above, I mentioned that maybe you are spending $300 on restaurants every month. If you instead put that $300 into your savings, you would be able to reach your goal much quicker! Doing this in combination with other techniques is a great way to easily reach your goal.
- Save your Tax Refund. If you are getting a tax refund this year then put all of it into your savings account as soon as you get it. Make sure you do this quickly so that you do not accidentally spend it. Your tax refund is not free money, it is money that you already earned but the government held onto it for you. You should consider adjusting your taxes so that you get more money in each paycheck next year.
- Sell Something. Selling something is an easy way to build your emergency fund. You could have a garage sale, sell stuff online, or sell something larger like your car. I’m sure when you look around your house, you would be able to find a few things that you don’t need. Facebook Marketplace is my favorite place to sell my old stuff. One man’s trash is another man’s treasure.
Building your emergency fund doesn’t have to be hard. There are so many different ways to build it quickly and easily. Once you have your emergency fund, you will feel a little bit more financially secure.
Emergency Fund vs Savings
A lot of people ask “what is the difference between your emergency fund and your savings?”. While they are similar, they have two different purposes.
An emergency fund’s purpose is to cover true emergencies; your car breaks down, your house roof starts to leak, etc.
Your savings should be used on things that you know are coming. This might include an oil change, insurance payment, gifts, food, etc. These are things that always happen. You know they are going to happen so make sure you have the money to cover them! This can also be called a sinking fund.
Emergency Fund vs Credit Card
I have heard people say that they have a credit card in case an emergency pops up. This is a great way to go into debt very quickly.
Our goal at Money Tree Network, is to help you live debt free! A credit card can have an interest rate as high as 30%. That means everytime you miss a payment, your credit card company is going to charge you up to 30%!
If you are using your credit car for an emergency you probably can’t afford to pay the bill. It can very easily turn into a disaster.
Now imagine if you had an emergency fund. Your emergency would go from a huge problem to an inconvenience. You don’t have to worry about paying 30% interest, all you have to do is make sure you put the money back into your account when you are able to.
To Sum It Up…
Emergency funds are vital in creating a financially stable life. They can save you when you lose your job, need a major car repair, or a major house repair. They will create a sense of stability that will allow a disaster to become an inconvenience. How nice would that be?
We learned that I suggest a 3-6 month emergency fund, and that this money should just go into a high-yield savings account or a money market account. Tell me some of the things you have spent your emergency fund on in the comments section below!