One of the first steps on the road to financial freedom is to build an emergency fund.
What is an emergency fund? It’s a pool of savings that you use to pay for major unexpected expenses. Typical emergencies you might address with an emergency fund include your auto insurance deductible after a car accident and paying living expenses for a short period after a job loss. This is an extremely important resource to have.
When an emergency strikes, our emotional focus is naturally on the crisis, not on its financial ramifications. A big emergency has us go all-out mentally and emotionally to confront the problem. Finances tend to get relegated to the back burner. This can lead to poor financial management during the crisis, costing us money in the long run.
How Much to Save in an Emergency Fund
There is no set answer to how much. Financial advisors typically recommend three to six months’ worth of living expenses (which should be somewhat less than your take-home pay). This is a fine starting point, but don’t get hung up on the number. Having something is better than having nothing saved for an emergency, which is where many people are at.
Don’t procrastinate trying to calculate an ideal number. Just start saving in a separate account to build an emergency fund.
There are a couple of big considerations in determining which end of the three- to six-month spectrum you should be on.
Income is one consideration. For example, if you’re a two-earner household with high-income, secure jobs and no other dependents, perhaps three months is sufficient. If you have some risk of a layoff, downsizing, or other potential interruption in income, perhaps you should lean toward the higher end.
Dependents who don’t earn a wage should factor into the equation, as well. They are a potential source of an emergency, not to mention a continuing expense should you lose your income. You should consider having a larger emergency fund if you have dependents than if you don’t.
Where to Keep an Emergency Fund
There are two overriding factors for determining where to keep an emergency fund: stability and accessibility.
Return isn’t as important. Use it as a tie-breaker if you wish, but don't treat it as a primary concern.
Stability is the number-one consideration. Your emergency fund needs to be completely available when an emergency occurs, and it shouldn’t be subject to market variations. This means that extremely stable places like savings accounts and money markets are the best options.
Accessibility is the second factor. Some emergencies require immediate attention. This means that your funds need to be immediately available — within reason. Since a three- to six-month reserve is supposed to fund both routine and extreme emergencies, 100 percent of the fund doesn’t need to be immediately available. If you have 20 percent available immediately, and the rest is available in two to three-day, that’s fine.
You can also consider investments like CDs for a portion of your emergency fund. Most CDs have a premature withdrawal penalty. Typically, the penalty is forfeiture of some or all of your interest.
Many advisors suggest not using them for an emergency fund due to the possibility of incurring this penalty. But if half of your fund is available without penalty, you would only risk occurring the penalty in the event of an extreme emergency. The rest of the time, you would earn higher interest than sitting in a regular bank account. The vast majority of the time, you win.
It’s actually quite simple. To get started, you should have a dedicated account for your emergency fund and an automatic method of funding it. Start now, even if you haven’t figured out exactly how much or how you plan on structuring it. You can make those decisions later.
For now, the most important thing is to get started. Otherwise you’ll never get there!
Consider opening a separate savings account at a local bank, a credit union, or even an online bank. Make sure that it’s an account that you can fund automatically and direct money from each paycheck into it. Start with what you can afford. Keep increasing it until you get where you want to be.
Also consider adding lump sums if money becomes available (from a tax refund, for example). Adding even a portion of your tax refund into your emergency fund can really jump-start your funding.
Hopefully you won’t need this fund often. But the peace of mind that comes from not needing to worry about where you’re getting the money to pay for a crisis is simply priceless.