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The Importance of Having an Emergency Fund

Updated on August 10, 2024 Updated on August 10, 2024
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Your future self will thank you for establishing an emergency fund today. It’s crucial to set aside emergency savings to cover unexpected expenses, whether it’s a sudden home repair or something more significant like unemployment. We’ll guide you in determining how much you need to save and provide practical steps to help you start building your emergency fund. Ensuring you’re prepared for life’s uncertainties will give you peace of mind and financial stability.

Having an emergency fund is one of the most important things you can do. It’s part of adulting. Your savings should be able to cover your major expenses for three to six months.

What is an Emergency Fund?

An emergency fund is a pool of liquid money set aside for unforeseen expenses like a medical expense or a car repair. Having an emergency fund can be the difference between a small bump in your financial life and a complete disaster in your entire life.

An emergency fund insures against life's unexpected expenses.

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Having a robust emergency fund gives you peace of mind. No one wants to live one paycheck away from not being able to pay the rent or one car breakdown away from not being able to get to work.

It also gives you some freedom.

If you decide to leave a relationship or your job becomes so unbearable that you have to leave before finding another or you want to go back to school or start your own business, having an emergency fund gives you the freedom to do those things.

Keeping that money separate from the money you use to pay bills can help curb frivolous spending.

Sometimes when you see a big number in your checking account you get a little cocky and a little more reckless. Keeping the money separate can help you avoid temptation.

What is an Emergency?

You should only dip into your emergency fund for a real emergency; to keep yourself afloat between jobs, for a car repair, a medical expense, or a home repair. You cannot use your emergency fund for things like a vacation, a shopping spree or to upgrade your perfectly good cell phone or laptop.

An emergency is not an expected expense, like buying Christmas presents, that you didn’t budget for a few months ahead of time. That’s what a sinking fund is for.

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How Much Should You Save?

Ideally, your emergency fund should be 3-6 months of expenses. That sounds like a lot and it is but keep in mind, that number can be your bare-bones expenses. If you were to lose your job your spending would be (at least it should be) different than it is when you have money consistently coming in.

The number you use to calculate your three to six months would include expenses like rent, utilities, car payments, etc. It does not have to include dinners out, entertainment, and clothing expenses, or saving for retirement.

Saving 3-6 months’ worth of basic expenses can seem overwhelming, especially since it often amounts to thousands of dollars. However, you don’t need to accumulate it all at once. Start by setting a realistic time frame to reach your six-month goal, but avoid stretching it out too long. Prioritizing the growth of your emergency fund is essential for financial security, so make consistent contributions and treat it as a top financial priority.

Let’s say your ultimate goal is $12,000. That means your bare-bones expenses are $2,000 a month. If you saved $400 a month, it would take 2.5 years to reach that number. That’s a reasonable timeline as long as you are saving that $400 every month.

Remember though, this is a priority. If you can throw an extra $100 a month in there, do it. Or you can use any “extra” money you get, a bonus, a raise, or monetary gifts, to help you reach your number faster.

Feeding Your Emergency Fund

Feel like you’re all tapped out and have no extra money to put toward your emergency fund right now? No fear. There are also a million ways to make some extra money on the side. We have over 100 ways here.

Americans typically spend around 2.7 to 3 hours a day watching TV. Instead of using all that time on the couch, why not use some of it to do something more productive or even make a bit of extra cash?

Make More Money

Spend one or two evenings a week driving for Uber. Get a few babysitting gigs on Sittercity. Set up a store on Shopify and sell items you make, resell items you buy, or go through your things and sell them there.

Earning more money is always preferable, but if finding extra time to boost income isn’t an option, there are plenty of effective ways to cut back on expenses.

Begin by reviewing your Monarch Money account to identify areas where you can reduce expenses. By analyzing your spending habits, you can pinpoint unnecessary costs and make adjustments that align with your financial goals. This proactive approach to budgeting can help you save more effectively and reach your financial objectives faster.

Cutting Expenses

Food is often a big budget-buster. Whether it’s groceries, takeout, or dining out, most of us spend more than we need to. The good news? Almost everyone can cut back on this area.

You can save a lot by hunting for deals and discounts. Just a little research and a few calls can lead to surprising savings on your food expenses.

Visit a site like Einsurance to compare rates for home, life, health, and car insurance. With so much competition in the insurance market, there’s a good chance you can find a better deal than what you currently have. Taking the time to compare options could lead to significant savings on your insurance premiums.

How high is the interest rate on your student loan? Credible may be able to lower it for you which not only saves you potentially thousands of dollars in interest but you will be able to pay it off more quickly.

If you’re paying off credit card debt that can hamper your ability to accumulate an emergency fund.

Look for a good balance transfer card. Some of them have a 0% APR introductory rate for up to 24 months. You can roll the balances from your existing cards to the balance transfer card and it allows you to pay only the principal with no interest so you can pay the debt down more quickly.

If you can’t get a balance transfer card, call your credit card company and ask them to lower your interest rate. They aren’t going to drop it down from 17% to 2% but even a small reduction in interest helps.

Lower Bills

How many of the dozens of cable channels that you pay for do you watch? You probably just watch a handful of shows. Could you watch those same channels through Hulu, Fubo or Max? Several of them combined are cheaper than paying for all those cable channels every month.

What do you buy regularly? Things like toothpaste, toilet paper, and cleaning products can be purchased through Subscribe and Save on Amazon. They are cheaper, you can schedule the shipments so you never run out, and you don’t have to spend time shopping for them.

Sign up for Cushion. It will analyze your transactions and alert you to any recurring charges, such as forgotten subscriptions or services you no longer need. While Cushion can help you identify these charges, you’ll need to cancel them yourself to save money.

Where Should You Keep It?

This is a controversial subject. Some people reach for the smelling salts when it’s suggested that an emergency fund is kept anywhere but a checking or savings account. And that’s understandable.

This money needs to be kept where it can be quickly accessed and where it will be safe. It’s reasoned that if you invest this money it may decline in value when you need it because of market volatility.

But what exactly is safe? Your money isn’t truly safe from inflation when it’s sitting in a low-yield account. Inflation averages around 3%, while most checking accounts offer less than 1% interest. Even though some savings accounts may currently offer rates above 1%, these rates are likely to decrease as interest rates fall. Over time, this means that year by year, you’re effectively losing money in the long run.

Keeping it in Savings

What $1 can buy today will take $1.03 to buy in one year. Three cents isn’t anything to worry about now but if you had that same $1 to spend in 1997, you would need $1.93 to make the same purchase in 2024. Now imagine not only are we looking at 20 years but thousands of dollars.

If you had saved the $12,000 emergency fund number from above in the year 2020, it would take $14,324 to match it in 2024. And some people will need a lot more than $12,000 to have saved six month’s worth of expenses.

It’s not just the loss of value due to inflation but the loss of growth when your money is parked in a low-yielding account. So what can you do that protects your emergency fund both from inflation and market fluctuations?

Investing Your Emergency Fund

Some financial writers advocate investing part of your emergency fund in low-risk assets to potentially outpace inflation. Betterment recommends putting your emergency fund in a portfolio split between 30-50% stocks and the remainder in a diversified allocation of bonds.

However, the above approach is not without risks, particularly in the event of a market downturn, which could reduce the value of the emergency fund just when it’s needed.

You could also invest your emergency fund in a Roth IRA where you can withdraw contributions (but not the growth) without penalty.

You want your fund to grow but you don’t want to keep all the gains it makes in that same pot because that additional money could be invested in a place where it will grow more quickly, like a fund set to a riskier allocation between stocks and bonds or your Roth IRA.

When your emergency fund is 20% more than the 3-6 months’ worth of expenses it needs to be, transfer that 20% to a different investment account.

A checking or savings account is the most liquid place to keep your money. Some financial investment accounts can take 3-4 business days to transfer funds. But if you have credit cards with a high enough limit, you could use that to pay for the emergency and pay it off when the funds transfer, paying no credit card interest.

When you sell investments, you might have to pay taxes on any profits. If you held the investment for less than a year, the profit is taxed as ordinary income. If you held it for more than a year, the profit is taxed at a lower capital gains rate.

What About Credit Cards?

Some people depend on their credit cards as an emergency fund. This is not the best solution but depending on the circumstances it isn’t the worst either.

If you have fluctuating income as freelancers or real estate agents do, you might not have all of the money to cover an emergency when it happens. You charge the expense on your credit card and pay it off relatively quickly when money comes in.

The worst-case scenario is losing your job, struggling to find new employment for weeks or even months, and having no emergency fund to fall back on. During this time, you may end up relying on credit cards to cover all your expenses just to stay afloat, which can quickly lead to accumulating debt and financial stress.

If You’re on the Fence

Still not sure whether or not you should invest your emergency fund this may help you decide. If you can answer yes to these questions, the risk of investing your emergency fund cash is further mitigated.

Do you have more than one income stream?

  • The greatest benefit of an emergency fund is the safety net it offers if you lose your job. Everyone is expendable these days and a lot of jobs will be automated in the future.
  • That’s why you need an emergency fund but it’s also why everyone needs more than one source of income.
  • That source could be a rental property, it could be dividend-yielding investments, a side hustle, or a part-time job. It doesn’t even have to be a ton of money coming in (although that would be nice), just so there is at least something coming in until you can find a new job.

Is your job secure? Again, no one is 100% safe but some of us have better job security than others whether that means you are secure in your role within a company, the company you work for is stable or the industry you work in is stable.

Is your job in demand? If you’re in a high-growth industry that is specialized, even if your company went under, you would be able to get a job more quickly than someone in an industry with low demand.

Do you have a 401k? You can “loan” yourself money to cover the emergency and then pay it back (see the link below for the criteria). This is another controversial subject within personal finance but it’s not the apocalyptic scenario it has been made out to be. Take a look at this in – 401k loans, and what you need to know.

Do you have a Roth IRA? As mentioned above, you can withdraw the principal from that for an emergency without penalty.

Money on the Table

It’s conventional wisdom that everyone needs an emergency fund but most everything else surrounding the subject is open to debate. The minimum in your emergency fund should be three months, some people advocate as many as eight.

Should you invest your fund or leave it in a checking or savings account? It depends on how much risk you’re comfortable with but the level of risk that many people talk about is overstated.

You don’t have to choose between risking your emergency fund in stocks or letting it lose value in a low-yield savings account. Instead, find a middle ground by splitting your fund between a high-yield savings account for safety and some low-risk investments for growth. This way, your money stays accessible for emergencies while still working to keep up with inflation.

Show Notes

Miranda Marquit: Miranda’s personal site.

Investable: Research and evaluate rental properties.

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Mark Fiebert - Contributor Mark spent over 30 years as a senior finance executive in Private Banking, Asset Management and Alternative Investments. Mark holds a BS in Accounting from Brooklyn College, an MBA in Finance from Pace University as well as being sponsored to attend The Wharton School Executive Development Program.

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