Build an Emergency Fund
An emergency fund is a cash reserve specifically set aside for unplanned expenses or financial emergencies. Examples include sudden and necessary auto repairs or an unexpected loss of income. You can use an emergency fund for unforeseen bills that fall outside your routine monthly expenses.
In this module, you'll find guidance on figuring out how much you'll need in your emergency fund, where you should keep it, and when you should (and shouldn't) use it.
Here are two brief videos, each less than four minutes, on the benefits of an emergency fund. Thanks to Khan Academy and Consumer Reports.
Why Do I Need It?
Without adequate savings you could be vulnerable to setbacks from even minor financial shocks, potentially leading to lasting debt. Individuals who struggle to recover from financial shocks usually have insufficient savings to shield against future emergencies. They might resort to credit cards or loans, which often results in debt that is difficult to repay. Alternatively, they might tap into other savings, such as retirement funds, to cover these costs. Using a retirement account to pay for short-term expenses can make it very difficult to reach your long-term goal of a safe and comfortable retirement.
How Much Do I Need in It?
While every person’s situation is different, a good rule of thumb is to have at least three months of expenses set aside in an emergency fund. If you get laid off from your job, you may need to cover six months of expenses (or more) until you get back on your feet. Even if you're living paycheck to paycheck or have irregular income, saving any amount, no matter how small, can provide a degree of financial security.
How Do I Build It?
The first step is to make a commitment to yourself to start the fund today. Even if you have very little extra income to contribute to an emergency fund, it’s okay to start small and build up your savings over time. For example, if you set aside $50 a month (about $12.50 per week), by the end of one year you’ll have $600 saved.
Next, set a goal for yourself: “In 12 months, I will have $________ set aside in my emergency fund.”
Then automate your savings. Ask your bank how to set up automatic transfers between your checking and savings accounts. On the day after your paycheck hits your checking account, transfer money from checking into savings for your emergency fund.
Let’s say your goal is to have $2,000 in your emergency fund in one year. If you get paid every two weeks, that’s 26 pay periods each year. Set up an automatic transfer to move $77 from your checking account into your savings account twice per month.
Establishing a system for making regular contributions promotes steady progress toward your goal. And regularly monitoring your savings and acknowledging milestones (the first $1,000 saved!) can provide encouragement to keep going.
Occasions such as tax refunds or monetary gifts present unique opportunities to swiftly boost your savings goal. While the temptation to splurge may be strong, allocating all or part of these windfalls to savings can speed up the establishment of your financial cushion.
See our module on How to Save Money for help on how to prioritize your savings.
Where Should I Keep It?
Since the money will sit there for a while until you need it, you should find an account that pays the highest interest possible with minimal risk. That means a bank or credit union savings account that pays interest or a money market account at the company that holds your investments. The money should not be invested in stocks, bonds, or other asset that could go down in value. The last thing you want is to be forced to access the emergency fund in a down market. Even bank certificates of deposit (CDs) are not a good place for your emergency savings. They often impose penalties if you withdraw the money before the maturity date of the CD.
A search online for “high-yield savings accounts” or HYSAs, will give you lots of options. Even if this account is not the bank where your paycheck is deposited, it’s easy to set up automatic transfers between banks.
Another option is to put the funds in a money market account at the company that holds your investments. These accounts often pay interest rates that are similar to HYSAs and you don’t have to complicate your life by opening an account at yet another financial firm.
Action Plan
Set your Goal
If you follow the 20-50-30 Savings Plan (see our How to Save Money module), here’s one way to figure out how much you need to save:
Item | How to Calculate | Calculation | Example |
|---|---|---|---|
Net Income
(Take-Home Pay) per Month | If you are paid every two weeks,
multiply your paycheck take-home pay by 2.166 | $1,385 x 1.266 = | $3,000 |
Needs (50%) | Net Income x 0.5 | $3,000 x .05 = | $1,500 |
Total Goal for a 3-Month Emergency Fund | Needs x 3 | $1,500 x 3 = | $4,500 |
Monthly Savings Goal | Pick a reasonable (and ambitious) figure that you can save each month | $225 | |
Number of Months Needed to Meet Your Goal | Total Goal ÷ Monthly Savings Goal | $4,500 ÷ $225 = | 20 months, (1 Year, 8 months) |
Automate Your Savings
Contact your bank about how to automatically and regularly transfer funds from your checking account to the savings account where you’ll keep your Emergency Fund. They should be able to step you through the process.
Once you’ve fully funded the Emergency Fund account, turn your attention to your Financial Goals. (See our module Set Financial Goals.)