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What Is an Emergency Fund and Why Do You Need One?
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Part of improving your financial health is having an ample emergency fund. This money, set aside to help you in case of the unexpected, is even more important in a time when more people are at risk of illness and job loss. Though there are plenty of reasons for having an emergency fund, prevention of debt is among the most important.
If you don't have an emergency fund, not to worry -- we'll break down what it is, why you need one, and how large it should be.
What is an emergency fund and what is it for?
An emergency fund is money you set aside in savings earmarked for emergencies. This money needs to be fairly liquid -- that is, you need to be able to access it quickly and easily.
Emergency funds are used for:
- Job loss
- Medical emergencies
- Unexpected car repairs
- House repairs
Of course, there are other types of emergencies. No matter what, the fund is there for unplanned events, as in, not for your semi-annual car insurance payments, or for holiday gifts -- expenses that are anticipated, and should come from other sources.
Why do I need an emergency fund?
Emergency funds can be thought of as a self-funded insurance policy of sorts. Instead of paying an insurance company, you're paying yourself by setting aside these funds for the future.
For example, if you lose your job, you'll have enough money set aside to pay for your expenses until you find another regular income source. Or if you know your car is going to rack up a lot of mileage, your emergency fund helps you prepare for the possibility of mechanical issues down the road.
An emergency fund is especially important if you don't have family members nearby who can help you in a pinch. You can feel safe knowing that if you need cash quickly, it'll be waiting for you.
How much do I need to save?
Your emergency fund and the amount of money you need depends on factors such as your current income and what your recurring expenses are. Most experts recommend setting aside an average emergency fund of three to six months' worth of expenses. However, if you have a job title like freelancer or gig worker, or you work on commission, you might want to set aside even more.
To figure out how much you need in an emergency fund -- aka the exact amount you need -- look at how much you spend per month on your necessary expenses such as rent, utilities, and food. Once you've determined your monthly expenses, just multiply that by three to six months.
Some people choose to save up three to six months of income, instead of three to six months of expenses. This is a more challenging goal -- but can provide extra padding in case of larger emergencies. So, if you usually make $3,000/month, you would save $9,000 for a three-month emergency fund.
Ultimately, how much to have in an emergency fund is up to you and how much you need for your bare necessities.
TIP
Emergency funds & coronavirus
With the COVID-19 outbreak still very much a part of our lives, it makes sense that many of us are relying on emergency funds right now. It might be a good idea to cut as much as you reasonably can from your expenses to prevent your emergency fund from going to zero.
Need more? Check out our tips on how to rebuild your emergency fund.
Where should I keep my emergency fund?
It's best to keep your emergency fund in a separate account, so you know it's earmarked for a specific purpose.
Here are a few options:
- Savings account. A savings account offers quick access to your cash. The best savings accounts offer a higher rate of interest and no monthly fees.
- Money market account. Similar to a savings account, a money market account can offer a higher interest rate, but you'll usually need to deposit a higher amount to do so.
- Certificates of deposit. CDs offer a fixed rate of return in exchange for keeping your money for a specified amount of time. But if you withdraw money before the maturity date, you could be subject to early-withdrawal penalties, which can negate the amount you would have earned in interest.
How do I build an emergency fund?
Building an emergency fund is fairly straightforward. Just follow these steps:
- Figure out how much you need in an emergency fund. Calculate the amount you need each month, and multiply it by the number of months you want to set aside.
- Set a savings goal. Knowing how much you want to save and by when you want to save it will help make your goal concrete and feel less overwhelming.
- Automate your savings. Consider setting up automatic direct deposits into your emergency fund. That way you don't have to worry about whether you're meeting your goals.
- Assess and adjust your goal. If you find you need to add more to your emergency fund, make some changes. Maybe you can use your tax refund, slash your expenses, or take on a part-time job. Then you can direct the cash straight to your emergency fund.
When should I use my emergency fund?
Your car breaks down
For many people, a car isn't optional. If your car is your only source of transportation to and from work, childcare, or necessary errands (such as groceries), an unexpected problem can seriously disrupt your life. Grocery delivery, ubers or rental cars, or even compensating friends for shared rides can become more expensive than simply repairing your car. If your car breaks down, don't worry about using your emergency fund for repairs -- that's what your emergency fund is for.
You lose your job
If you lose your source of income, you could face life-changing challenges. Falling behind on your mortgage could mean losing your house. Falling behind on your rent could mean an eviction. Skipping a utilities bill could mean getting the power cut. It's a good idea to use your emergency fund to pay for necessary expenses if you lose your job. By keeping up with your bills, you give yourself a better chance of getting back on your feet quickly.
You have a large unexpected medical bill
No one wants to face a bill insurance won't pay. With unexpected surgeries, hospitalizations, or other medical costs, you might find yourself wondering how to pay for your medical care. These are the emergency situations that your emergency fund is meant to take care of. You may need to make a plan to pay for your unexpected medical costs over time, but don't hesitate to use your emergency fund to help ease the costs.
Your home needs a vital repair
Did your heater break in the middle of winter? (Or your AC break in the hottest part of the summer?) Do you have a broken window? Did your basement recently flood, or your house foundation crack? If your home needs an important repair, use your emergency fund to take care of it. These problems are much more expensive if left alone for months. Don't feel guilty about dipping into savings to keep your home in good shape.
FAQs
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An emergency fund is money you set aside for unexpected events such as a job loss, medical problem, or car breakdown.
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Most experts recommend setting aside three to six months' worth of expenses, or more if you're self-employed or have variable income.
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It's best to keep your emergency fund separate from your regularly used accounts, but in an account you can access quickly. Some options include a high-yield savings account, money market account, or a certificate of deposit.
About the Author
Sarah Li Cain has been writing financial advice and reviewing financial products since 2015. She has contributed to outlets including LendingTree, Business Insider, Redbook, Bankrate, and the Financial Planning Association.
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