Unexpected expenses are bound to pop up eventually, whether it's a sudden illness or injury, car problems, a flooded basement, or any other cost you weren't planning for.
Although these types of costs are inevitable, many households aren't prepared for them. In fact, only 61% of Americans have enough savings set aside in a fund to cover a $400 unexpected expense, according to a report from the Federal Reserve Bank.
However, establishing an emergency fund can be more beneficial than you may realize. People who have healthy emergency funds are around 2.5 times more likely to feel confident about reaching their long-term financial goals, according to a survey from AARP. And there are three specific reasons why building a solid emergency fund can improve your financial situation.
1. It can help you save more for retirement
If you're hit with an unexpected expense and don't have an emergency fund, you may choose to tap into your retirement account to cover the cost. After all, your retirement fund is essentially a huge savings account, right?
In truth, pulling money from your retirement savings can do some serious damage, both short-term and long-term. In the short-term, you'll be charged a 10% penalty and be required to pay income taxes on funds you withdraw from your 401(k) or traditional IRA before age 59-1/2. And in the long-term, you could be missing out on thousands of dollars' worth of potential investment gains by withdrawing or even borrowing money from your retirement fund.
Your investments rely on compound interest to help them grow over time, meaning your cash grows exponentially the more time it has to sit untouched in your retirement account. So when you take money from your retirement fund -- even if you pay it back later -- you're stunting your investment's potential growth.
By creating an emergency fund, you can avoid tapping your retirement savings to cover unexpected expenses. That, in turn, will allow your savings to grow more over time.
2. It can keep you out of debt
Without an emergency fund, you may be forced to rack up credit card debt or take out a loan if you incur an unplanned expense and don't want to touch your retirement savings. But debt -- especially credit card debt -- can be incredibly expensive, and potentially cost you hundreds or even thousands of dollars in interest alone.
High-interest debt is particularly toxic because it's easy to fall into a vicious cycle. As the interest charges snowball over time, you may end up putting so much money toward your debt payments that you can't afford other expenses -- which leads you to rack up even more debt. And if you're slammed with another unexpected cost before you've fully paid off the first one, then you'll just end up digging yourself deeper into debt.
An emergency fund can help avoid the harmful debt cycle altogether, because if you're hit with an unexpected cost you can pay for it out of your savings and stay debt-free.
3. It can help avoid a financial disaster if you lose your job
One of the best reasons to establish an emergency fund is to protect yourself if you lose your job and are forced to go without a steady source of income for any length of time. Most financial experts recommend saving enough to cover at least three to six months' worth of general living expenses so you won't fall into financial despair if you lose your job.
If you lose your job and don't have an emergency fund, you could face a domino effect of consequences. You may be forced to take on debt just to pay the bills, and if the debt repayments get too overwhelming you might have no choice but to pull money from your retirement savings. Even once you do find another job, it could take months, or even years, for your finances to recover. And if you tapped your retirement fund to make ends meet, your investments may never fully recover over the long run.
Not having an emergency fund could potentially cause irreparable damage to your finances. So although setting aside a few thousand dollars in a savings account may be a tedious task, it can potentially save you far more than that in the long-term. By creating a healthy emergency fund now, you can prevent loads of financial frustration down the road.