What You Should Know About Saving an Emergency Fund
Having a emergency fund could be what saves you from the downward cycle of debt
Emergency Fund: Definition
According to Investopedia, your emergency fund is money set aside for covering unexpected expenses. You use the fund to create a financial safety net so that you don’t get into debt due to a financial emergency. Having a fully funded but not too accessible emergency fund is important for your financial future. It could be your key to not falling into the next 5 years of always being behind the debt ball.
Why You Need an Emergency Fund
Everyone runs into problems. It could be a sudden car repair that happens when you need to get to work. Or a tooth that the dentist needs to pull. If you’re like me, you’ll get an emergency room bill from 6 months ago where your health insurance paid everything except for the $100 after-hours fee.
A large number of Americans believe that a high-limit credit card may be the answer. In fact, almost half of Americans would use a credit card to pay for an emergency.
But that strategy has problems as well. Credit is this weird thing where you must use credit to have credit but using too much credit makes you less creditworthy. I wouldn’t be surprised if you had to read that sentence a few times. Let’s take a practical look at this.
Let’s say you have a $2000 credit limit on a credit card. If you get close to the credit limit a creditor could see you as a risk. They could then decrease your credit limit to below your current balance. Worse, they could jack up your interest rate astronomically high like 24% (happened to me).
It’s much better to have your own pot of money that you can dig into if you need it. It’s interest-free and you don’t have to fill out an application to use it. What is this miracle money? It’s an emergency fund. An emergency fund will help you cover the unexpected expenses that always pop up when you don’t need them to.
How Much Should You Save in an Emergency Fund
There are several schools of thought in this area. Most financial advisors will give you the standard advice of 3 to 6 months of expenses. This is good blanket advice but what’s more important is what you need your fund for. You want to be able to cover your expenses in case you lose your income streams. That could be your job, your side hustles or your bank interest. If you were to lose that how are you going to pay your bills? Write out one month of your recurring expenses. Don’t forget to add in any bills that come every two months like a water or refuse bill.
Your emergency fund should be able to cover all those monthly expenses for any given amount of time. The amount of money you need in your emergency fund is your monthly expenses multiplied by the number of months you want to be covered. For example, if you spend $700 a month then to fund a 3-month emergency fund you will want to save $2,100.
How Long Should Your Emergency Fund Cover
Again, the standard advice is 3 to 6 months. Base your answer on your needs. How long will it take you to replace your income streams? If you think it will only take you 3 months then save that. If it will take you longer save enough to cover that length of time.
But don’t get hung up on formulas. It doesn’t matter how small or large your fund is. The point is to have some money saved so that you don’t get in debt over small emergencies.
By now, you’ve at least thought about the number of bills you have a month. You think you’ll never able to save that amount of money on your own. Those are big numbers especially if you are new to saving or don’t make enough money to be able to save that much. That’s understandable in this job market. If those are too high for you (right now) then start by trying to save $1000. One thousand dollars is the perfect amount to save in the beginning. Even if it doesn’t cover all an unexpected expense it will take the sting out of one.
Where Should You Put This Money?
This depends on your banking situation. A bank account that you don’t have easy access to is optimal. A bank account with a high-interest rate is better. A bank account that can do both is key. The best ones to do this are online banks that offer high yield interest rates. This account should be with a different bank than where your money normally goes.
A high yield savings account is good as well. Again this should be a different bank than your regular one. If you are having trouble finding a local bank, consider online banking options. Some of the best rates can are online.
A third option is to put your money in a money market account. I won’t go too much in to money market accounts here because it’s a little bit of an advanced topic. But here’s what you need to know for now.
Most money market accounts have a required minimum balance. The good part is that the higher the minimum balance the better the interest rate normally is. The bad part is how high the minimum balance can be. It’s high enough to price you out in the beginning but it can be an option once saving becomes more routine. So when you are on the hunt for emergency fund’s home, compare the high yield savings accounts with money market accounts.
When Should You Start Saving?
As soon as possible. Start saving before some awful circumstance happens. If it already happened it’s not too early to lick your wounds and save for next time.
Keep the Saving Momentum Going
Most people don’t get into debt because they are totally irresponsible with money. Most times, it’s because we didn’t have enough when we needed it. We can further get ourselves into debt with a defeatist mindset. I have so many personal examples of this but here’s a good example.
A real emergency happens i.e. my car breaks down. I had to spend so much money that I feel like I should at least have something that makes me happy from it. So I buy a new make-up palette. Or more likely, some Copic markers. Those might not be good examples for you but I guarantee you have a secret money vice you sink your money into. Insert that. The point is that spending the fund causes you to lose your momentum so you overspend.
To combat this save a small slush fund in addition to the emergency fund. This fund should be at least 10% of your emergency fund and definitely no less than $100.
Your emergency fund is one of the first things you can develop to get on the way to financial independence. It will keep you debt-free and have you covered in case of an emergency. Don’t let debt creep its way into a permanent position in your life. Take control of your debt and gain financial independence.