It's widely agreed among experts that one of the first big financial moves you should make is starting an emergency fund. Before you focus on investing, or paying down debt, save at least $500 to $1,000 for emergencies. Over time, aim for an emergency fund with three to six months of living expenses.
Not everyone does this. Case in point, the median savings account balance is only $1,200 -- a far cry from three to six months of living expenses for most people. To be honest, building your emergency savings is a chore, and it's not the most exciting part of personal finance. It's understandable why you'd be more interested in saving for a house or investing to grow your money.
That doesn't mean it's a good idea. Because when you don't have enough in your emergency fund, you're leaving yourself exposed to some serious financial issues.
1. Going into debt to cover emergency expenses
Imagine a worst-case scenario where you lose your job or have an unexpected $5,000 bill. If you have a large emergency fund, you can make a withdrawal to cover your expenses. It's still not pleasant, but at least you were prepared.
If you don't have enough money saved, what are you going to do? You need to pay your bills, and that means you'll need to borrow money from somewhere. That may mean you either:
- Run up a balance on credit cards, which have an average interest rate of 21.47%.
- Get a personal loan -- 24-month personal loans have an average interest rate of 12.35%.
Those are high rates, so interest could end up costing you a significant amount.
If you're in a jam, there are at least 0% intro APR credit cards. Some of them have intro periods of 15 months or longer where you don't get charged interest. However, you typically need a high credit score to qualify. You'll also still be going into debt, and after the intro period ends, the 0% APR will shoot up to the card's normal rate.
2. Not being able to make payments on your accounts
Borrowing money can help you get by in an emergency, but it's not a long-term solution. In fact, it can make it even harder to recover financially, because you're adding debt payments to your monthly bills. You'll need to pay back the money you borrow through loans or credit cards.
Let's say you're living paycheck to paycheck. You take home and spend $4,000 per month. Unfortunately, you end up with a $5,000 car repair or hospital bill. To pay that off, you get a 24-month personal loan with a 13% interest rate. You've taken care of the immediate issue, but now you have a $238 monthly loan payment.
Hopefully, you're able to make it work and get all your bills paid. But what can eventually happen is that you're unable to make your required monthly payments. With credit cards and loans, this likely means getting charged late fees, pushing you even deeper into debt. There's also another way it can seriously hurt your finances.
3. Damage to your credit score
When you're unable to make payments on an account, that gets reported on your credit history. It doesn't happen right away -- your account needs to be at least 30 days past due. Once you're late by 30 days or more, it can cause severe damage to your credit score.
The exact amount varies depending on your credit history before the late payment. For consumers with excellent credit, a single late payment can cause a credit score drop of up to 110 points. It gets worse if your account becomes 60 days and 90 days past due, and if the creditor eventually decides to charge off the account and send it to collections.
If this happens, it can take a long time to rebuild your credit. Late payments and charge-offs stay on your credit file for seven years. It doesn't take quite that long to get good credit again, but it's a process that can last multiple years.
A strong emergency fund is a must
An emergency fund is a crucial part of being financially secure. If you don't have one yet, or if yours doesn't have at least three months of living expenses, make that a priority for 2024.
Figure out how much you can afford to save for your emergency fund every month. Then, set up automatic transfers to your savings for that amount. Make sure to use a high-yield savings account for your emergency fund, too, so you get a competitive interest rate.
It takes time to build an emergency fund, but you'll be glad you did. It gives you the peace of mind that you're ready for anything.
