No matter how we may plan, stuff happens. Your glasses break. Your car needs work to pass its emissions test. The water heater goes out. Your employer announced layoffs – and you’re one of the victims.
Unexpected expenses seem to show up more often than windfalls. That’s why you need to set aside money for emergencies in your budget. If not, you’ll end up turning to credit cards or – worse – a payday lender, making your financial crunch much worse and last much longer.
The way to budget for setbacks is to put money in an emergency fund. Here’s everything you need to know about setting up an emergency fund and saving money to put into it.
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What is an emergency fund?
An emergency fund is money you’ve set aside and do not use to pay regular bills. Instead, you save it for a financial emergency, such as a car crash that leaves you suddenly needing to buy a new car or a job layoff when you have to pay bills with no paycheck coming in. It’s separate from money you might be saving for a down payment on a new home or a bucket list vacation. You only dip into it to pay for absolute necessities when your regular checking account runs out.
What is a financial emergency?
A financial emergency is not an unexpected invite to a weekend trip to Vegas or being a few dollar short for a new iPad. A financial emergency is a time when you have a sudden, unplanned-for threat to your livelihood or extremely high bills for absolutely necessary expenses. Experts lump these emergencies into three categories:
- Threat to income: You lose your job and need to pay bill recurring bills. Or, something breaks, like your car or laptop that is essential to your ability to work.
- Threat to health: You get diagnosed with a major illness or are hospitalized after a bad accident. Any situation in which you unexpectedly find yourself needing life-saving or major medical intervention counts as a financial emergency.
- Threat to home: A tree falls on your house, requiring extensive roof repair. A pipe bursts and your kitchen floods. If a problem makes your home unlivable, it counts as a financial emergency because you will need to repair the damage ASAP.
How much should I have in an emergency fund?
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The usual guide for an emergency fund is to have three to six months of living expenses readily available. The amount should cover your rent or mortgage payments and utilities; your car payment, gas and insurance premiums; minimum payments on credit-card debt and other loans; and the costs of food, medicine and toiletries.
If you don’t have a budget already, you’ll need to do some math. Start by going through your checking account statement or your credit-card bills to make a list of all your regular expenses. Don’t forget annual expenses that you pay once or twice a year every year, but not monthly. These could include your car insurance or a credit card fee.
Establish the minimum amount of money you need to live on each month. That sets the basis for your emergency fund.
If that number is intimidating, even $500 or $1,000 is a fine start for your emergency fund. At the very least, see what you can spare from your current savings or unspent cash this month to seed your emergency fund. Your goal will be to start putting away money each month and grow your emergency fund until it can cover several months of necessary living expenses. Something is always better than nothing.
How long should it take to build an emergency fund?
How long it takes to build an emergency fund depends on how much you can sock away each month and how high your regular living expenses are. If you have tons of savings, simply allocate the correct amount into a separate emergency fund and you’re done.
For most of us, that’s not possible. You’ll need to build your emergency fund over time. Look at your budget and determine how much you can spare each month. If you put $100 into your emergency fund each month, you’ll have $1,200 (plus interest) by the end of a year. Take more of your paycheck to put into your emergency fund, and you’ll fund it more quickly. Experts estimate that with a smart saving strategy, you can build up your emergency fund in 6 to 18 months.
Where do you invest your emergency fund?
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Put your money into an account that is separate from your regular checking account. However, it should be in a very safe investment, such as a savings account or a money market mutual fund. You won’t get much return on the funds, but that’s OK. You want your money to be liquid; in other words, you can take it out easily, without fees, when you need it. However, if you can find a no-fee account that pays even a little bit of interest, then your money can grow while it sits in the account, waiting for you to need it.
Don’t pay a service charge on your savings account; it will eat into your money. Online banks such as highly-rated Ally offer free savings accounts with no minimums.
Benefits of budgeting for an emergency fund
As you get better at budgeting, reducing your expenses and paying off debt, the amount of money that you need in your emergency fund gets smaller – and you’ll find it easier to pay unexpected expenses from your regular income. That gives you more power over your finances, although not over life itself.
With any luck, the emergency fund will be money that collects a little bit of interest and nothing more. However, if life takes weird turns, as life so often does, you’ll be able to turn to this money instead of going into debt.
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We established an emergency fund the minute we got married 22 years ago. We also keep the amounts of all deductibles (auto/home/health insurance) separate in our budget. So we always have $6000 for that if we’d get hit with claims (health works a bit differently) from all of our insurance accounts in one year.
The best way to budget, IMO, is to annualize everything then break it down by the number of paychecks. So not only do monthly and yearly bills get divided by 26 each year, but also gifts, vacations, clothes, etc. Putting away, say, $80 per paycheck, allows for a nice vacation. That money is not touched and builds all year until we go on a trip. It’s there in case we absolutely would need it for something else, but otherwise it is just sitting, waiting. Added to our emergency and deductible funds, it allows us to make a higher interest rate on our accounts.
For us a CD is not a better option as we get 1.5% on our checking account. CDs are not paying that well and our money is available 24/7.