How to Create an Emergency Fund
When you are working to get your finances in order, it’s crucial to understand how to create an emergency fund. It’s just the simple truth—unexpected problems are going to happen. And many of these problems are going to cost you money. That’s why saving for emergencies isn’t just a nice thing to do—it’s an essential part of your financial well-being as well as a necessary part of your long-term financial success. So this article explains what an emergency fund is and how you can create an emergency fund to start saving for unexpected financial challenges.
What is an emergency fund?
Before determining how to create an emergency fund it is important to understand exactly what an emergency fund is (and what it isn’t; see the section at the end of this article).
An emergency fund is a savings account that you set up specifically for when unexpected events happen that cost you money to resolve. So, for example, an emergency fund can be used to pay for needed car repairs if you do not have enough money yet in a car maintenance fund to pay for such expenses. It could be used for home repairs that you haven’t yet been able to save up for, or for a sudden job loss, or medical expenses. Unfortunately, there are many types of financial emergencies that can happen, but with a fully funded emergency fund, you can be prepared for these events.
Why do I need an emergency fund?
An emergency fund is crucial because you are going to have emergencies! You’re not immune to challenges and problems. The average American family faces a large financial setback (of several thousand dollars or more) at least once every 10 years, so you need to be prepared for that eventuality. And less severe financial hardships that cost $1,000 or less happen more frequently than that.
How much do I need to save in an emergency fund?
Your goal should be to reach a fully funded emergency fund (EF) of three to six months’ worth of expenses (not income) as quickly as possible. If you don’t know how much that is, then it’s time to create a monthly budget! 🙂 If you can, try to save this amount in 12 months or less, once you have paid off all nonmortgage debt.
In general, I recommend leaning toward a six-month emergency fund if you can. Personally, I think the extra peace of mind is important and may give you the courage to do the other things with your finances that you need to, like investing in good stock mutual funds for retirement. However, if you have two incomes, you are in a stable job situation, you don’t have any major medical conditions in your family, you are not anticipating any major life events soon (like the birth of a child or purchase of a home), your house and your vehicles aren’t too old, and so on, then a three-month emergency fund may be fine for your circumstances.
Set up automatic transfers to transfer money into your emergency fund savings account every time you get paid or at least once a month until your EF is fully funded. Even if you’re in a situation where, because of a tight budget and circumstances where you or your spouse may not be able to take on much extra work, you can’t save very much each month, even $50 to $100 will add up over time and go a long way toward providing a needed barrier between you and Mr. Murphy.
Where should I keep the money in my emergency fund?
Your emergency fund money should be in a separate savings account at a bank where you have a (fairly) easily accessible checking account so that you can transfer the money over fairly quickly and use it if needed. Though you probably won’t get as high of an interest rate, you may want to have your EF money in a brick-and-mortar bank, not an online bank, so that you have virtually instant access to it either by stopping at a nearby bank branch or by transferring the money from your EF savings account to the linked checking account so you can withdraw the money at any ATM with your debit card.
You could also use a money market account at your local bank or credit union for your EF. Don’t keep the money for your emergency fund in your checking account—that’s a sure way to end up spending it. Again, make sure the money is in a separate savings account. And even though it should be accessible in case you need it, don’t make it so accessible that you are tempted to spend the money for anything else besides emergencies.
If you decide to use an online bank, these are some good options for places to put your emergency fund:
Capital One 360. This is the account that we use for our emergency fund. We’ve been customers since the time that this branch of Capital One was ING Direct, and though I was sad to see ING go and though I’m not a fan of big banks, I have to say that our experience with Capital One has been great. On the couple of occasions where we needed them to fix something with our account (both times were minor things we did that were our fault, not theirs), they did it right away with a simple phone call, and their customer service was great. And they still offer one of the best savings rates around. You can see their . One of the things that I love about our Capital One 360 account is that you can open multiple (and by multiple, I mean we now have more than 20) savings accounts for the different things you want to save for beyond just your emergency fund. It’s awesome!
HSBC. We’ve simplified some, but there was a time when we collected bank accounts like some people collect postage stamps. And another one of the online banks we tried out was HSBC. They’ve been a good bank for us, and we’ve never had any problems with them. And similar to Capital One 360, you can open multiple savings accounts that all link to your checking account, and they offer rates far better than most the of the local brick and mortar banks.
Schwab. Schwab has been a great bank for us. This is the first brokerage firm we used, and it’s still where we do the bulk of our investing for our Roth IRAs, children’s education savings accounts (ESAs), and other long-term investing. Though their savings rate is not as high as some of the other online banks, there are no account minimums or service fees, and they offer unlimited ATM fee rebates worldwide. In addition, when it comes to investing their fees are very competitive and in some cases even better than Vanguard’s for comparable funds, which is one of the reasons that we went with them in the first place.
Ally Bank. We don’t have a bank account with Ally, but I have heard great things about them and know that they also have very good savings rates, so they’re another option you should check out if you’re shopping around for a great savings rate.
Dollar Savings Direct. This is another bank that I’ve heard very good things about. They too have one of the best savings rates around, with low minimum balance requirements.
How can I save for my emergency fund?
A crucial part of knowing how to create an emergency fund is understanding how you can actually save the money for the EF. Here are three crucial things you can do to save the money for your emergency fund.
Sell stuff. There are probably things around your house that you aren’t using that you can sell on eBay, Craigslist, or your local online classifieds. Or you could have a garage sale. By selling a few electronics or well-cared for furniture items, for example, you could be well on your way to a starter emergency fund of $1,000. Or maybe you have a motorcycle, jet ski, snowmobile, or similar item that could be sold. Have a car in your driveway that seldom gets used? Sell it and you might be pretty close to having a fully funded emergency fund.
Work to increase your income by getting an extra job or taking on a side hustle. There are so many ways that you can earn extra income these days. And many of them you can do online without ever even leaving your home. You could work from home as a customer service representative, become a mystery shopper or do online surveys or user testing, drive for Lyft or Uber, rent out an extra room on Airbnb, become a virtual assistant, or, my personal favorite, even blog for profit! I talk more about many of these opportunities in this article on earning extra income. You could also do overtime at work or get a part-time job, or take on extra clients or work if you own your own business.
Reduce necessary spending and eliminate (for a time) unnecessary spending. Cancel your cable or satellite service, cancel subscriptions, quit eating out and slash your grocery spending, do a spending freeze for a period of time, and make other cuts where you can. Treat funding your emergency fund like an emergency! (That way, when you have a financial setback or emergency, you’ll have accomplished this goal quickly so that you’ll be prepared.) For more information on how to reduce your spending, see this article.
What should I use my emergency fund for?
An emergency fund should be used only for—you guessed it!—emergencies. Don’t use it unless it’s an actual emergency. That could be an unexpected funeral, an illness, or something that goes wrong that you haven’t yet saved up money (or enough money) for in a separate account to cover (but that you eventually should!), such as a car repair or home repair or needed dental work or similar expense.
Expenses that you should plan for—such as car repairs and maintenance and home repairs and maintenance (once you have adequate funds in these savings accounts to start covering these expenses), a great sale, birthdays or weddings, family vacations, and so on—should not come out of your emergency fund.
Again, knowing how to create an emergency fund is an essential part of your overall financial success. And so is actually funding it! When you have an emergency fund with enough money in it to cover most things that could go wrong, there’s something in your psyche that changes. You know that pit in your stomach that you get when you don’t have the money to pay for something you really need like a car repair or a new-to-you appliance to replace one that stopped working? With an emergency fund, that feeling will happen far less often, and when you get to the point where you have a fully funded emergency fund, that feeling will virtually go away altogether. A part of you that may never have relaxed before is able to. An emergency fund means peace of mind, and that is priceless. Believe me, the effort (and maybe even sacrifice) it takes to get your fully funded EF in place is well worth it!
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