No matter how much you plan, there are some things in life you just can't anticipate -- a car wreck, a sudden illness, a rough patch of unemployment.
That's why when it comes to your personal finances, it's best to follow the old adage "expect the unexpected" and set yourself up with an emergency fund.
In this video from our YouTube channel, we explain what a good emergency fund looks like and how to start building one up over time.
A full transcript follows the video.
Narrator: Hey! I'm Motley Fool contributing writer Maurie Backman, and on this episode of FAQ, we're walking through what an emergency fund is, and why everyone needs one.
Life has a way of throwing unwanted surprises at us when we least expect them. Your car could break down without warning. Your roof could spring a leak, or you could fall, break an elbow, and land in the hospital with a huge bill to follow.
You could also find yourself out of a job if your company is forced to downsize its staff – even if you're a solid performer who's been working there for years.
That's why we all need emergency savings – money to get us through those tough times and help us pay those unexpected bills.
Ideally, you want enough cash in the bank to cover three to six months of essential living expenses. That way, you can cover either a large unplanned bill or get yourself through a period of unemployment.
Now by "essential expenses," we're talking about your rent or mortgage payment, fuel for your vehicle, food, electricity, and medical care -- things you can't really cut back on or live without.
To figure out how much money you should have available in the bank at all times, figure out what you spend each month on essentials, and then multiply that figure by three, six, or somewhere in between.
Which end of that spectrum should you choose? Well, it depends on what your expenses and obligations look like. If you're single, you don't own a home or car, and there's no one who counts on you financially, then you're probably OK to stick to the low end of that range and bank three months of expenses. On the other hand, if you have children to support, and you own a home or car, you should probably stick to the higher end.
Another thing: The money in your emergency fund should be tucked away in the bank, where it can sit in cash. You shouldn't invest your emergency savings because if you need that money in a pinch, you don't want to worry about selling investments at a loss to access it.
So now that you know why you need an emergency fund and how much money it should ideally contain, the question is: How are you going to build it?
There are several ways to establish emergency savings, but first, let's get one thing out of the way: No one expects you to build a full emergency fund overnight. It might take several months, or well over a year, to reach your emergency savings goal, but the key is to start right away and keep at it until that fund is complete.
One of the easiest ways to build an emergency fund is to create a budget, see what you spend each month, compare that figure to your earnings, and see what you have left over.
If, for example, you bring home $4,000 a month after taxes, but your expenses typically cost you $3,800, you're only going to be left with $200 a month to bank. Meanwhile, if your essential monthly expenses -- meaning, the ones you can't live without -- total $2,400, you'll need $7,200 for a three-month emergency fund. And if you have no money in savings currently, a $200 monthly contribution to your emergency fund just isn't going to cut it.
The beauty of having that budget, however, is that it'll help you see where you have room to cut back on spending so that you're able to sock away more money each month. For example, if you're currently blowing $400 a month on store-bought lunches, restaurant meals, and takeout, preparing all of your food at home for a while might free up an additional $300 a month. Add that to the $200 you already had the ability to save, and suddenly, you're putting $500 a month into your emergency fund – not too shabby.
Next, look at getting yourself a side hustle. Everyone is doing it these days, and if you find something you enjoy, it won't even feel like work. And if that second gig is really lucrative, you could easily be looking at another $500 a month to build your emergency fund.
Finally, if you get your hands on extra money during the year, whether it's a tax refund, a birthday gift, or a bonus at work, do yourself a favor and stick it right in the bank. It'll help you reach your goal faster, and once that happens, you'll get the peace of mind that comes with knowing you're protected against unplanned expenses.
Like it or not, financial emergencies can happen to all of us and strike at any time. Without an emergency fund, you risk racking up major debt the next time something like that happens to you. So build up that three to six months of cash reserves, and then leave it alone until you really need it. Remember, you shouldn't use your emergency fund to pay for a vacation or holiday gifts. Its purpose is to protect you from unplanned expenses, so resist the urge to touch that cash for other purposes, even though you know it's there.