Overall, Americans are feeling optimistic about their finances. Nearly eight in 10 U.S. adults say they expect to be better off financially in 2020 than they were in 2019, according to a recent survey from Fidelity Investments.
However, it's important to stay vigilant and not let your guard down. Even if you're feeling confident about your money right now, there's one thing that could potentially devastate your entire financial situation -- and it's more common than you may think.
These costs could wreck your finances
The No. 1 financial concern Americans have about the future is the threat of unexpected expenses, the Fidelity survey found. That's a valid concern, considering even relatively minor unexpected costs can cause major financial damage.
Only around 60% of Americans have enough savings to cover a $400 unanticipated expense, the Federal Reserve Bank discovered. But these types of costs are more dangerous than they seem, because they can cause a domino effect of consequences.
Say, for instance, you're hit with a $2,000 unexpected cost, and you don't have any emergency savings. You choose to charge it to your credit card, but because you're unable to pay the bill in full the next month, you're stuck racking up interest charges. As your interest payments snowball over time, that makes it harder to save for retirement, build up an emergency fund, or tackle your other financial responsibilities. Then if you're hit with another unexpected cost down the road, you end up digging yourself into a deeper hole, and it becomes more challenging to get your finances back on track.
The long-term consequences of unexpected expenses can be severe, too. If you take on credit card debt, you could end up paying hundreds or even thousands of dollars in interest alone. And if you tap your retirement fund or postpone saving for retirement to pay for an unexpected expense, that decision could come back to haunt you come retirement age when your nest egg isn't as strong as you'd hoped.
Although unexpected costs are unpredictable, the best defense against them is a healthy emergency fund. When you have some cash stashed away for a rainy day, you can avoid some of the nasty consequences of unplanned expenses.
How to establish an emergency fund
Most experts recommend saving enough in your emergency fund to cover around three to six months' worth of general living expenses, although any amount is better than nothing. Even if you can only manage to pull together a couple of hundred dollars right now, that money will still protect you against some unexpected costs.
As you're building your emergency fund, it's also important to think about where you're going to store your cash. You'll want to keep your money where it's easily accessible, but you also want to earn a good amount in interest. For those reasons, a high-yield savings account is one of the best places to park your money. Many high-yield savings accounts offer interest rates of around 2% per year (far more than the dismal fraction of a percent you'll find with a standard bank savings account), but unlike investing in your 401(k) or IRA, you can withdraw your money at a moment's notice without facing any penalties.
Building a well-stocked emergency fund is especially important as you get closer to retirement because it will be tougher to cover unexpected expenses when you're living on a fixed income. And if you end up withdrawing more than you should from your retirement fund to cover these types of costs, that can derail your entire retirement plan. So as you're nearing your golden years, aim to beef up your emergency savings as much as you can to create some extra financial cushion.
Unexpected expenses are a part of life, and they can cause more financial destruction than you may think. However, if you prepare for them by creating a solid emergency fund, you can ensure they won't knock your long-term financial plans off track.