You’ve probably heard something along the lines of “40% of Americans couldn’t afford a $400 surprise expense.” Let’s clear this now – this misquoted statistic originated from a poll run by the Federal Reserve in 2017. And the question asked respondents how they would pay for a $400 expense.
Many subsequent surveys have been conducted, and unfortunately the news still isn’t that great. Broadly speaking, the reports are saying that less than half of Americans have at least three months’ worth of expenses saved up in an emergency funds.
If you are one of the super-planners out there who already has at least three months of expenses saved up, good for you!
If you haven’t figured out where to start, worry not! We’ll start with the basics and help you figure out exactly how to get your emergency started.
Table of Contents
What is an Emergency Fund?
An emergency fund is a nice big pile of cash that you have on hand for a very specific purpose, and it’s not paying off student loans or taking that trip to Tahiti that you’ve always wanted.
It’s for large, unplanned expenses or for extended periods where you suddenly won’t have income, such as getting laid off from your job.
Why Do I Need One?
In the US, many health insurance policies – even the best ones through employers – can have exorbitantly high deductibles. Even after deductibles are met, there might still be money owed to pay for hospitals, procedures, or anything else health-related that is only partially covered.
If the worst were to happen and you got into a car accident, you can bet that any hospital bills that might follow will cost a lot of money.
Some health insurance policies can have around $1,000 deductibles, while some can be as high as $7,500 for a single person and $15,000 for a family.
What if you lost your job tomorrow? Not to scare you – you’re probably a great employee, but even the safest companies to work for might suddenly need to make cuts. The Covid-19 lockdowns in 2020 were a perfect example.
While many governments lent monetary support to citizens during that difficult time, it did not come immediately. An emergency fund needs to be there when you suddenly don’t have any money coming in and you need to buy groceries.
You might think of your credit card as money that is at your disposal in an emergency. This is not a good idea because of the huge interest rates and the hit you’ll take to your credit score. If you don’t know your credit score, it might be a good idea to check it regularly on sites like Rocket Credit Scores.
You might need six months’ worth of expenses, and that can put you in dangerous interest charge territory on your credit card and ruin your credit score.
How Much Do I Need to Save For an Emergency Fund?
Since you don’t want to stockpile all of your money in cash (more on that later), you will ideally need at least three months’ worth of income saved up in an emergency fund.
If you are single, this is a very simple calculation. Just multiply your take-home (after-tax) paycheck by 3. If you’re married, add your incomes together and multiply by three.
You might be wondering why the rule is three months. To be perfectly honest, this calculation is just as arbitrary as it sounds. However, three months is usually quite a bit of money and would carry you through most emergencies.
Are There Any Different Ways to Calculate It?
Believe it or not, there are several schools of thought when it comes to the exact amount you need to save. That’s mostly due to the fact that everyone is living with different circumstances.
If you find yourself in a situation where you have debt payments stacked against you and feel like you can’t put together even one months’ worth of income, then it’s best to start with saving up just $1,000 while you tackle the debts.
That may not seem like much, but you’re creating a buffer between you and having to dive into more credit cards. Even a small buffer is better than none at all.
The next step after saving $1,000 and paying off debts might be to go for an emergency fund that can cover your expenses for a set period of time. Calculate the total monthly expenses on major and recurring items like rent, car insurance, food, etc., add them together, and then multiply by perhaps three months.
If you are the type of person to need a bit more security, many financial gurus out there would suggest you double the original three months to six months’ worth of income.
Where Do I Deposit and Keep My Emergency Fund?
You want your emergency fund to be completely accessible within a very short period of time. Here are the Dos and Don’ts for where to stash your emergency nest egg.
• DO keep your emergency fund somewhere you can access all of it within three days. Remember that most emergencies won’t require you to pay up big bucks all at once, so you have a little time to get the money into your account.
• DON’T put your emergency fund in any investments where there is risk involved. Not only does this complicate the withdrawal timeframe, but it also opens up the possibility of losing your money.
• DO keep your emergency fund in cash or cash equivalents. This means a high-interest cash account, a money market fund, or something similar.
• DON’T keep your emergency fund in your regular bank account. If you access your account every day, you’ll more than likely see your emergency funds just sitting there. One day, you might convince yourself to dive into that money. Keep it in another bank where you won’t look at it constantly.
How to Go From $0 to Fully Funded
Now we come to the hard part – actually saving up the money for an emergency fund.
The best way to start is to put together your budget showing every dollar you spent last month and will send it in the months to come. After that, find out how much you have remaining, not including spending on nights in the town, entertainment, or restaurants. Take either a small portion of your remaining budget or, better yet, all of it to put towards your emergency fund.
Most banks will allow you to set automatic deposits, so you won’t even have to think about it. Alternatively, you can use mobile apps like Acorns that round up your expenses and automatically round up to generate a bit of cash on the side.
Don’t Most Finance Gurus Say Cash Is A Bad Investment?
Cash is definitely one of the worst “investments” you can make. This is due to inflation. When you keep money in cash, that cash loses value each year that is equal to the inflation figure for that year.
Let’s say inflation is 5%, which it is as of this writing. Your cash will technically lose by worth 5% less next year than it was this year. While the face value of your cash doesn’t change, the prices for goods will go up every year at the rate of inflation – sometimes even more.
That being said, your emergency fund should only represent a small portion of your net worth, but it’s absolutely essential that it remain in cash so it’s easily accessible.
What’s Next: Your Emergency Fund
Remember that the emergency fund is an important part of your financial journey, so it should take priority above any other short- or long-term goals. You will also need to remember to re-calculate whenever your circumstances change – and they will change. Even though you might have an emergency fund for yourself when you were single, everything changes when you’re married. Re-calculate on a regular basis to make sure you have adequate protection.
