What would you do if your car needed major repairs? What about if you lost your job or were hospitalized for a long time? These are all things we don’t want to think about but they are very important to budget for. If you save for these types of situations it will hopefully make that stressful time a little less stressful. Emergency funds are important to keep you safe if you do have an emergency. So, how much should you save for an emergency fund? We will answer this question and more below.
What is an emergency fund?
An emergency fund, or a rainy day fund, is money that you have set aside for life’s unexpected events. If you lose your job or need to pay a large medical bill, having an emergency fund will help protect you against the worst-case scenarios.
Why do I need an emergency fund?
The answer is very simple: to avoid debt. The main reason to have an emergency fund is that you simply don’t know what’s going to happen. The Covid-19 pandemic emphasized just how important it is to have additional money saved in an event of a job loss or serious illness. It allows you to get through a tough financial time without having to take out a loan or accumulate charges on your credit card. The last thing you want to be doing in an emergency is stressing about how you are going to pay for that emergency.
A recent survey from Bankrate found that 35% of Americans have less in their emergency fund now than before the pandemic started. 13% have more than before the pandemic started and only a quarter have enough saved to cover six months’ worth of expenses. 21% of people have no emergency savings at all. During the Covid-19 pandemic, many emergency funds were drained. It’s important to start saving for an emergency fund to reduce your stress in the future.
How much money should you have in an emergency fund?
When it comes to an emergency fund, there is no one-size-fits-all approach. If you have any debt, then you will want to start with a smaller emergency fund of around $1,000. If you manage to put away $100 a month, you will already have a $1000 emergency fund in less than a year.
Once you are debt-free, most experts recommend an emergency fund of 3-6 months worth of essential expenses. An essential expense is those that you truly need to live. This includes things such as food, rent or mortgage, transport, and utilities. Start by making a list of the essentials you spend money on each month to determine how much you need to save for an emergency fund. For example, if you spend around $2,500 per month on essential expenses, then you should try to save between $7,500 and $15,000. However, in some circumstances, you may want to save up to 12 months worth of expenses.
Another consideration to take into account is how stable your income and household are. If you are part of a two-income household, or you have had a steady income for several years, then you may only need to save 3 months’ worth of funds. If you own your own business, or if someone in your household has a chronic illness, then you may also want to save 6-12 months’ worth.
At the end of the day, there is no magical number. It’s important to think about your situation as this will help determine what your goal should be. It has to be based on what makes you feel secure. No matter how long it takes you to get to your goal, it’s important to just start. You will be that much closer to staying ahead of the unexpected.
How can I build my emergency fund?
- Set a realistic budget: Calculate your monthly income and normal expenses. Once you have done the calculation then it is easy to see where your money is going and how much money you can save. You can also use a budgeting app to help with this. Once you can see how much money you can save, then you can decide how much you want to put towards your emergency fund each month.
- Calculate one month’s worth of essential expenses: When you calculate how much your essential expenses will be, make sure that you only calculate things that you would still pay in an emergency. These can include things such as groceries, rent, and bills.
- Set a monthly savings goal: This is how much you want to set aside each month towards your emergency fund. Even if you are micro saving $10 per month, it is still better than not saving at all. You will be one step closer to having an emergency fund if you ever do need it.
- Automate your savings: Once you have determined your goal and how much you are going to save each month, then set up an automatic transfer. Automating your savings is one of the best things you can do to help you achieve your goal.
- Save unexpected income: If you come across some extra money such as a tax refund, bonus, or a monetary gift, then use that extra money to deposit into your emergency fund to reach your goal sooner. Once you hit your emergency fund goal, you can start investing that extra money somewhere else.
- Adjust how much you save: As you go through life, you may want to adjust your emergency fund and how much you save. If you have a pay increase at work, you may want to use that pay increase to increase how much money you are putting into your emergency fund.
Where should I keep my funds?
Your emergency fund should be easy to access and in an account that earns interest. However, having an account with high interest is less important than being able to access the money quickly and easily.
Some of the best options include a simple savings account connected to your checking account, a money market account that comes with a debit card, or an online bank that pays a higher interest rate but still allows you to quickly transfer money to your checking account. It is best to put this money in a separate account so you can’t just dip into it whenever.
When should I use the funds?
When you have a sudden expense, it can feel like an emergency. However, make sure you have criteria in place to ensure that the sudden expense is really in need of the emergency fund. It shouldn’t be used to take a vacation or to spend on new clothes. It is money that you have just in case a situation comes along where you truly need that money.
An emergency fund is an important part of a solid financial plan. When you do start an emergency fund, how much you save really comes down to you, your situation, and how much you feel comfortable with. It can seem like a lot at the start but it will be worth it if you do ever need it. You don’t need to save it all at once. It is designed to keep you safe in an emergency, and only you will know what the right amount is for you and your family. A financial planner can help you started with your emergency fund and keep you on track to meet your goal.
Alvin Carlos, CFP®, CFA is an investment advisor and fee-only financial planner, in Washington, D.C that works with clients across the country. He has a Master’s degree in International Relations from SAIS-Johns Hopkins. Alvin is a partner of District Capital, a financial planning firm designed to help middle-class professionals achieve their financial goals through smart investing, reducing taxes, retirement planning, and maximizing their money. Schedule a free discovery call to learn how we can help elevate your finances.