An emergency fund is exactly what it sounds like – it’s money you’ve set aside to use in the event of an emergency. Emergencies can range from an unexpected vehicle repair to a major crisis such as a job loss. The cost to you could be only a few hundred dollars or up to several thousand dollars, so how can you determine how much you should save?
The exact amount you should save depends on several factors such as your income, your budget, and your comfort level.
What Is an Emergency?
First, let’s discuss what an emergency is. An emergency is an unexpected expense that you haven’t budgeted for. Your cat needs surgery, your refrigerator stopped working, the transmission on your car went out, or some other event occurred that was unexpected and cost you money. It’s essential to use your emergency funds only for actual emergencies – it is not just another savings account!
Why Should You Have an Emergency Fund?
The first thing most of us turn to in a financial emergency is credit cards. Credit cards can be a useful tool as a part of your normal financial decisions, but credit card bills can quickly rack up and become overwhelming if you rely on them to float you through an emergency. Having cash on hand allows you to cover emergencies without breaking a sweat, and gives you the freedom to use your credit cards wisely.
Now let’s look at how to determine how much money you ought to save in your emergency fund.
How Much Money Should Be in an Emergency Fund?
One way to decide on your emergency fund is to look at your monthly budget. If there were an absolute emergency (such as a job loss), what expenses would you cut out? Netflix, eating out, gym membership, and other extras are some of the things you would stop paying for if there were an actual emergency. However, items such as food, housing, utilities, transportation costs, and other necessities will still need to be paid for.
Once you’ve cut out all of your “extra” items, take the number that is left as your bare-bones expenses. Multiply that number by the number of months you are comfortable with, and that will give you an ideal figure to shoot for as a starting point for your emergency fund.
As an example, let’s say your typical monthly budget is $3,000, but after you cut out all the extras, you brought the number down to $2,500. This is your bare-bones monthly budget. You want to save about three to six months of that amount, so your emergency fund should be between $7,500 and $15,000.
Three or Six Months of Expenses?
When determining how many months to save for, you should look at a couple of factors.
First, is your household a dual-income household or a single-income household? If you are a single-income household, it’s wise to save six months of expenses. In a dual-income household, even if one loses their job, the other would most likely still be earning an income. A three-month emergency fund is probably sufficient in this case.
Second, is your income variable because it’s based on commission, or because you are self-employed? If so, saving six months of expenses will keep you prepared for potential lean months as well as any incoming emergencies.
Third, no matter what your answers to those questions are, you have to consider your comfort level (and that of your significant other, if you have one). Some people just feel more comfortable knowing that they have a larger emergency fund in the bank, and there’s nothing wrong with saving more than you need to.
Where Should You Keep an Emergency Fund?
An emergency fund needs to be available on short notice, so it should be kept in a liquid, easily accessible account. A high-yield savings account is a great place to keep an emergency fund. While the returns won’t be as high as they would be if you invested it, the fact that you can pull it out at a moment’s notice is the most critical consideration.
How Do You Get Started?
Saving three to six months of expenses sounds daunting. When you get that number on paper, you might be thinking that there is no way you can save that much money. The good news is, you don’t have to come up with that number tomorrow! Save up one thousand dollars as a starter emergency fund, and you’ll be well on your way. A thousand dollars will cover many emergencies, and it’s a good starting milestone to shoot for. Once you have that amount saved, keep adding to it as you can until you hit your goal number.
An important thing to remember about emergency funds is that if you take money out, as soon as the emergency has been dealt with, it’s time to replace that money. It is there to be used, but make sure you replenish the funds so that you can draw from them next time there’s an emergency.
Part of making wise financial choices is planning for the unexpected. By building up an emergency fund, you’ll be better prepared for whatever life may throw at you. Knowing that you can take care of yourself and your family in an emergency relieves financial pressure and will help you sleep better at night.