What Is an Emergency Fund?
The term “emergency fund” refers to money stashed away that people can use in times of financial distress. The purpose of an emergency fund is to improve financial security by creating a safety net that can be used to meet unanticipated expenses, such as an illness or major home repairs.
Assets in an emergency fund tend to be cash or other highly liquid assets. This reduces the need to either draw from high-interest debt options, such as credit cardsorunsecured loans, or undermine your future security by tapping into retirement funds.
Key Takeaways
- An emergency fund is a financial safety net for future mishaps and/or unexpected expenses.
- Emergency funds should typically have three to six months’ worth of expenses, although the 2020 economic crisis and lockdown has led some experts to suggest up to one year’s worth.
- Individuals should keep their emergency funds in accounts that are easily accessible and easily liquidated.
- Savers can use tax refunds and other windfalls to build up their funds.
- Some employers have established programs to encourage emergency fund saving.
Understanding Emergency Funds
You establish an emergency fund when you put away money that is intended to be used during times of financial hardship. This includes the loss of your job, a debilitating illness, or a major repair to your home or car—not to mention the kind of major economic crisis and lockdown that happened in 2020.
The best size for an emergency fund depends on a number of factors, including your financial situation, expenses, lifestyle, and debts. Many financial advisors recommend saving enough to cover anywhere from three to six months’ worth of expenses, which can help you weather a modest healthcare bill or a short bout of unemployment.
However, some experts argue for an even heftier cushion. Celebrity finance guru Suze Orman, for example, suggests an emergency fund that can handle up to eight months’ worth of outlays. And she made that contention well before the 2020 crisis, a stark reminder of how sudden and deep an economic slump can be.
Individual circ*mstances may dictate the specific savings level with which you’re comfortable. For example, a single adult without children may be content covering three months of expenses, while the sole breadwinner for an entire family may want to have enough to cover half a year or more. Research shows that many Americans are well short of the recommended range. In fact, a 2020 survey by the Federal Reserve found that more than one-fourth of Americans lacked the ability to cover a $400 expense with cash or its equivalents. Among unemployed workers, that figure rose to 45%.
If you’re living paycheck to paycheck, you may want to start with more modest goals, such as putting 2% of your net income into a rainy day fund and slowly increasing your contribution rate every few months. Even a modest safety net can help buy you a little time should you face an unforeseen financial crisis.
It may be tempting to use your fund for incidental or frivolous purposes, so make sure that you don’t deplete this resource for any purpose other than an actual emergency.
How to Build an Emergency Fund
Starting early is the key to setting up an emergency fund, because it helps you build up a comfortable cushion against unexpected emergencies later in life. Getting a start on emergency funds is relatively easy. Here are two simple ways to begin saving for one.
- Set aside a comfortable amount from your salary each month. Calculate your living expenses for the desired period, and make that your target for an emergency fund. You can then divert a portion of your paycheck—perhaps by setting up an automatic transfer—to that account each month. Once the fund is built up, invest extra savings for the long term or other goals, such as the down payment on a mortgage. Once you’ve maxed out your retirement savings, that money could go into an investment account with higher risks and rewards.
- Save your tax refund. You may be tempted to think of a tax refund or stimulus check as extra money for discretionary spending. Instead, consider diverting it toward your emergency fund to give you an added financial cushion.
You probably want to park your emergency fund in a vehicle that can be easily liquidated should a financial need suddenly arise. While storing cash in a savings account may be the safest approach, there are other relatively secure ways to store a part of your emergency fund that offer greater interest-earning potential. These include high-interest savings accounts, money market accounts, and no-penalty certificates of deposit (CDs), which don’t charge savers a fee if they need to pull their money out before the maturity date. You’ll have the access you need in an emergency but won’t be incurring fees and time delays associated with other vehicles, such as brokerage accounts.
You may want to build an emergency fund before venturing into volatile investment vehicles such as stocks. The latter offer greater long-term growth potential than cash and cash equivalents, but their value can suddenly decrease in the event of an economic downturn, as the 2020 economic crisis and lockdown made vividly clear. Should that be the moment when you need to tap them, you could lose more value. An emergency fund protects your portfolio against that risk.
Tip
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Helping Employees Save
A number of major employers have introduced programs encouraging emergency savings because of the effects of financial instability on productivity and retirement security. Here’s a sampling of programs from three major companies.
- Truist Financial Corp.: Through its Truist Momentum program, the parent of SunTrust and BB&T banks offers $750 to employees who complete an eight-part financial education program, then open and fund an emergency savings account. More than 48,000 employees have graduated as of Aug. 6, 2021, according to the company.
- Levi Strauss & Co.: The apparel brand gives hourly employees up to $240 each in matching funds through its Red Tab Foundation when they make qualifying contributions to their savings accounts over a six-month period. Workers also receive a $20 bonus when they link their bank account to the company’s online platform.
- Prudential Financial Inc.: Retirement plans administered by Prudential allow employees to divert part of their paycheck toward a savings account, encouraging them to create a financial safety net. This feature serves as after-tax emergency savings and allows employees to withdraw the funds if an emergency arises, while preserving their before-tax retirement contributions.
Example of an Emergency Fund
Here’s a hypothetical example showing how to assemble an emergency fund. Let’s say a married couple has monthly expenses totaling $5,000. This includes the couple’s mortgage payments, food bills, car payments, and other necessary outlays. Using the three-month rule, the couple needs to set aside at least $15,000 (or $30,000 for six months and $40,000 for eight months) to address any unexpected financial burdens.
How much should I have in an emergency fund?
The amount varies according to your living expenses, but the general rule of thumb is to eventually save three to six months of living expenses.
How can I create an emergency fund if I am living paycheck to paycheck?
It won’t be easy, but instead of worrying about your eventual savings amount, decide on a percentage of take-home pay that you can do without. It can be 1% or 2%. The important thing is to save a set amount each payday and not touch it. The money will add up.
What is an emergency fund for?
As simple as the answer seems, it is important to make sure that you can distinguish between what is an emergency and what isn’t. An emergency is an unexpected bill that you can’t pay—not money to go to a movie or for some other nonessential expense.
