Personal Finance Post

Why You Need an Emergency Fund and How to Build One

Anna Klawitter November 16, 2020

We’ve all experienced unexpected financial emergencies—a fender bender, an unexpected medical bill, a broken appliance, a loss of income, or even a damaged cell phone. Large or small, these unplanned expenses often feel like they hit at the worst times. 40% of American adults wouldn’t be able to cover a $400 emergency with cash, savings or a credit-card charge that they could quickly pay off, a Federal Reserve survey finds.

Setting up a dedicated savings or emergency fund is one essential way to protect yourself, and it’s one of the first steps you can take to start saving. By putting money aside—even a small amount—for these unplanned expenses, you’re able to recover quicker and get back on track towards reaching your larger savings goals.

The emergency fund is your safety net, in the event of such bad surprises. It gives you a buffer to keep you going till the time you figure out a more sustainable solution for the situation. An emergency fund will empower you and grant you the freedom to make good decisions in the time of a crisis.

If you’re living paycheck to paycheck or don’t get paid the same amount each week or month, putting any money aside can feel difficult. But, even a small amount can provide some financial security. Here’s some questions to ask yourself before you start building your emergency fund.

 

What is an emergency fund?

An emergency fund is an account set aside to gather money for emergency use. The emergency itself may be anything, but it’s wise to plan for the worst. Emergency funds are something that you can’t create overnight. It can sometimes take over a year to build a fund sufficient to meet your minimum emergency needs and years to build up a more robust amount of savings. 

 

How Much Money Should I Have In My Emergency Fund?

As much as a necessity an emergency fund is for everyone, how much money it should have is up to each person’s needs and requirements. Conventional wisdom says to save for 3 to 6 months worth of your monthly expenses including rent, mortgage, major bills, food, etc. Do not get discouraged by this number. The most important thing is to start saving. The amount you need to have in an emergency savings fund depends on your situation. Think about the most common kind of unexpected expenses you’ve had in the past and how much they cost. This may help you set a goal for how much you want to have set aside. 

 

What if I can't save 3 to 6 months of living expenses?

Saving three to six months of living expenses is recommended, but if expenses are tight, it may be really hard to do that, and it could take years. If you find yourself in this situation, don't get discouraged and give up on the idea of an emergency fund. Instead, make a commitment to start small.. 

A $1,000 emergency fund will be enough to cover many unexpected financial surprises that come up. You can save $1,000 over the course of a year by putting aside just $38.50 per pay period if you're paid biweekly.  Over time, continue making contributions to your emergency fund -- as much as you can afford -- and eventually you'll reach that goal of having three to six months of living expenses saved up. 

 

Where Do I Keep This Emergency Fund?

Where you put your emergency fund depends on your situation. You want to make sure this fund is safe, accessible, and in a place where you’re not tempted to spend it on non-emergencies. Here are a few options for where to put your emergency savings, and you can choose which one will work best for you. 

You need safe, liquid options so that your money is accessible in times of need. High-yield savings accounts offer excellent liquidity. Some people also opt for checking accounts, but separate your savings into a new bank account. This will allow you to look at it as a different source and not be tempted to use it for other things. Then, set up an automatic transfer of the amount that you decided upon. As long as things happen on its own, your savings will grow without much effort.

But considering that your emergency fund will be sitting idle for a long period of time, it is best to opt for an account that lets your money earn some interest and allows easy access as well. These choices make it harder for you to dip into it, and you’ll also earn a bit of return on the money. Just ensure that this interest-gaining account also allows you to withdraw from it for little to no penalty. 

Now let's look at next steps on how to start building your Emergency Fund.

 

1. Set a goal

Before you do anything at all, decide how much money you want in your emergency fund, say, six months from now. Once you decide that, as mentioned above, break it down to achievable pieces. Decide on a specific number per week or month, whichever is easier for you to keep track of. Knowing this number will also help you decide how much spending or what expenses you need to cut down on to meet your goal. 

Write your goals down. Goals that you write down are 52% more likely to be successfully achieved. Try this savings planning tool or this Emergency Fund Calculator to calculate how long it’ll take you to reach your goal, based on how much and how often you’re able to put money away. 

 

2. Track your money

You should know your spending and earning habits well enough to decide how large of an emergency fund you're going to need. After you  know how much you should set aside every month, you need to know where to take it from. For this, you need to know what your money is doing every day. The best way to know this is by tracking your transactions, if you don’t already. It will give you a clear picture of what is standing between you and your saving goal.

 

3. Manage your cash flow

Your cash flow is essentially the timing of when your money is coming in (your income) and going out (your expenses and spending). If the timing is off, you can find yourself running short at the end of the week or month, but if you’re actively tracking it, you’ll start to see opportunities to adjust your spending and savings.

For example, you may be able to work with your creditors (like your landlord, utility companies, or credit card companies) to adjust the due dates for your bills, or you can use the weeks when you have more money available to move a little extra into savings. This is one important first step in managing your money, regardless of whether you’re living paycheck to paycheck or have a tendency to spend more than your budget allows. 

 

4. Find Unique Ways to Add to your Savings

It can be hard to find ways to set aside extra money, but look for ways that money could possibly be slipping through the cracks. Are there any services or expenses you could do without or cut back on?

Here are some ways to get started.

  • Treat your emergency fund as a bill. Add your emergency fund to your regular bills; this will give it a sense of priority. If you need to start small, such as $10 per month, that’s still a good starting point.
  • Take stock of all the goods and services that you use that are not strictly necessary, such as services you could perform yourself or spur of the moment spending choices, and put that extra money into your emergency fund.
  • Put all loose change into a special jar just for your emergency fund. 
  • If you get a cash gift for your birthday, a holiday or another special occasion, you can add it to your emergency fund. 
  • Due to their size, tax refunds are a great stack of money to add into your emergency fund.
  • If you have stocks, bonds, or mutual funds that pay regular income, you can divert that into your emergency stash for a while. 
  • Sell things you don’t need. If you want to get a good perspective on it then I suggest you check out Gary Vaynerchuk and his series Trash Talk. Most of us have old phones, toys, exercise equipment, electronics, etc. that you can sell and turn into cash.

 

5. Tackling Debt While Saving for an Emergency Fund

Instead of trying to put extra money toward debt, build up your emergency fund first -- and see if there are ways to reduce your interest rate while you're doing so.

Make minimum payments on your debt while you focus on building at least a starter emergency fund of several thousand dollars. 

Once you have a few thousand dollars in the bank for emergencies, you can divide your extra cash between debt repayment and building up the rest of your emergency fund. Or, you can shift your focus to debt repayment until you get that taken care of and then aggressively build your emergency fund up to the three to six months' living expenses goal once the high-interest debt is gone.

You'll have to decide which approach is best, given the interest rate on your debt and how much risk you face of experiencing a really big emergency.

An emergency fund is intended to help you stay out of debt, but what if you're already in debt?

Deciding whether to save up an emergency fund or focus aggressively on paying down debt is difficult. Your lender likely charges a much higher interest rate than you'll earn on your emergency fund, so it may seem silly to have money sitting in the bank while you pay interest. 

However, in almost every case, it makes sense to save for an emergency fund before beginning an aggressive plan to pay down debt. This never means skipping minimum payments -- you always need to pay the minimums. But, unless you have very high interest consumer debt, like payday loans or a credit card with a penalty interest rate, it makes sense to save for an emergency first. 

While the math may point you in the other direction, the problem comes when that inevitable emergency strikes. If you've been sending all your extra cash to your credit card and your transmission breaks or you lose your job, you may find yourself charging another $2,000 on a credit card that you just paid off.

This can make you so discouraged that you stop taking steps to improve your finances. You could also become trapped in the never-ending cycle of paying down debt and then ratcheting it back up when an unexpected expense arises.

 

6. Consider a Side Hustle 

There are only two ways in which you can increase your savings. Either by spending less or by earning more. Around 44 million Americans have a side hustle, according to a Bankrate survey, and more than a third of them make more than $500 monthly from their side gig. You could build your emergency fund quickly by working a side job for a limited period of time. 

Negotiate a raise or take up side gigs, at least for a short period of time, to save up a good enough fund. If you have the time and the drive to make some side money, then this will speed up the process greatly. It can also turn into a long term hustle and a good way to make some extra money on the side long-term. There are many ways you can go about this and I would recommend getting supplemental income revolving around something you are passionate about. There is an abundance of freelance work out there for any passion. Look into websites like Fiverr, Upwork, and Freelancer if you are considering freelancing.

If you are not considering freelancing and just trying to find easy work that you can just sign up for — there is an abundance of apps out there where you can make some cash. Try apps like Doordash, Uber, and Instacart. 

You also have the option of just getting another part-time job, but, that is a bigger commitment than signing up for an app or doing freelance work.

 

View your emergency fund like an insurance policy. Once you have it, guard it carefully. Set some guidelines for yourself on what constitutes an emergency or unplanned expense. It’s not a piggy bank. You should not use it for incidental expenses or pull from it when you want to buy something new. 

Use the fund only in the event of an emergency and spend it carefully when you do need to draw on it. Remember, once that money is spent, it always takes much longer than anticipated to replace it. Start now and save whatever you can, even if it isn’t much. However, don’t be afraid to use it if you need it. If you spend down what’s in your emergency savings, just work to build it up again. Practicing your savings skills over time will make this easier. Looking for more financial wellness tips? Check out the Meratas blog!

Topics: Personal Finance

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