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Building your savings is essential, but building a solid foundation for your savings to rest upon is even more critical. You need an emergency fund. What good is savings if it can easily wash away? In this article, we cover how to plan your finances around the unexpected, but inevitable curve balls that life throws at us.
What is an Emergency Fund?
An emergency fund is a cushion of money you have set aside for emergencies. Don’t use the money in your emergency fund for any planned expenses.
What is an Emergency Fund Used For?
Asking “what is an emergency” might seem silly, but I know many people who poorly define “emergencies.” An emergency is an event that you could not plan for. Examples might include:
- A car accident
- An injury or illness in the family
- Natural disasters
- Job loss
Anything you couldn’t have possibly anticipated. With many emergencies, insurance is typically involved, which means you only need to save as much as your deductible plus any out-of-pocket expenses. We’ll get into that later.
How to Start an Emergency Fund
- Start a Money Market or Checking Account.
- Create a partial direct deposit from your paycheck into this account.
- Let the money grow.
- Don’t touch the money unless you have to.
Where Should I Put My Emergency Fund?
There are a few great places to put an emergency fund. The traditional place to put your emergency fund is in a money market account or a checking account. I keep my emergency fund inside of a Betterment “Safety Net” goal, which I’ll talk about shortly.
Why Use Money Markets and Checking Accounts for an Emergency Fund?
The short answer is accessibility. Being able to write a check directly from the account makes things easy to manage when you’re going through a bad situation. Money market accounts tend to offer higher interest rates, so you get a little more income from your savings versus putting it into a checking account.
First, start a money market account at a bank. These earn a decent amount of interest, and they allow you to write up to 6 checks against it each month.
If you can’t start a money market account, then you can go with a standard checking account, but make sure the money is difficult for you to access. Consider opening an account with a different bank other than the one you usually use. Limiting your access will help you avoid the temptation to spend the money.
Why Use a Betterment “Safety Net” Goal?
Now, I keep the majority of our emergency fund in a Betterment “Safety Net” goal. Betterment is a fantastic “Robo-advisor” that does a lot of financially-savvy things for me. By using their “Safety Net” goal, I’m able to keep about 15% of my emergency savings invested in stocks, and the other 85% in bonds.
Saving inside of Betterment allows me to get a much higher return on my savings while still staying moderately safe. Read my full Betterment review if you want more detail on everything Betterment has to offer.
I know you might think this sounds “risky,” I mean, what if the stock market drops and I have an emergency? Betterment suggests that you over-estimate the amount you’ll need for this exact scenario.
So, my emergency savings fund is 30% higher than I need, but it allows me to get a higher return without the concern of not having enough for an emergency. I keep around 20% of our emergency fund in a traditional money market account, but the remaining 80% is inside Betterment.
Setup a Partial Direct Deposit
After you have set up the account, see if you can set up a partial direct deposit with your place of employment. Some employers will allow you to direct deposit money into one account, and the remainder of your check into another.
If your employer doesn’t allow this, or you are self-employed, then consider setting up an automatic transfer from your checking account to your emergency fund account. Many banks allow this.
Let the Emergency Savings Grow
Over time, your emergency savings will build from a few twenty-dollar bills a month, into a few hundred, then into a few thousand. An event could occur before you have saved enough money, but even cutting the bill in half is worth it, and then you continue building your fund. However, you must act like this money does not exist!
Only Use Your Emergency Savings If You Must
This money is not meant to pay for a new TV, or a new bed set, it is intended to help you in a real emergency! I highly suggest opening a new account with a bank other than the one you currently use. That way you aren’t tempted to transfer money out of your Emergency Account into your checking to use.
What is a Good Amount for Emergency Savings?
The generally accepted rule of thumb is at least 3-6 months worth of your expenditures.
So, if your monthly cost of living is $4,000, then you need between $12,000 and $24,000 in savings.
To save six months’ worth of expenses, you must total all of your bills including electric, water, groceries, gas, and all other fluctuating bills (overestimate to be safe) and multiply that number by 3,4,5, or 6.
Generally speaking, you want the savings amount to be higher than:
- 3-6 months worth of living expenses
- or, your highest insurance deductible plus your max out-of-pocket
I would suggest choosing the higher number, but it’s your choice. Saving 3-6 months’ worth of expenses should protect you in the event of a job loss or a medical emergency.
I suggest planning for six months of expenses because it’s the most stable and it will give you half a year to find a new job and stop living off of the savings, but it is up to you. If that seems too impossible right now, then start with three months as your goal, and once you reach it, move on to 4 months, then five months, and then finally six months.
When Do I Use The Emergency Fund
Many people fail because they make their money too available and visible. Many people like to watch the money grow, and they take pride in seeing what they’ve accomplished. The problem with this is that you are always well aware of how much money you have in there. Out of sight is out of mind, and you must succeed in this.
Don’t spend this money on:
- An “emergency sale” at JC Penneys.
- A new bedroom set you have always wanted.
- Car repair.
Wait, isn’t fixing the car an emergency? No! You know your vehicle will break down! You should already have separate savings for that! Build it into your budget if you haven’t already.
The emergency fund is a catch-all for the unforeseeable like:
- A kid breaking an arm
- A car accident.
- Job loss.
Your emergency fund isn’t for an unexpectedly high electric bill or an unexpected shopping trip with old college friends. It isn’t for an expensive cell phone bill because you needed to binge-watch Game of Thrones on your phone between classes. Use emergency funds for significant events that you weren’t expecting. The kind of situations that leave you in disbelief.
Should I Build an Emergency Fund Before Investing?
Generally speaking, yes. However, that is the most conservative answer. If you have a financial advisor, or you’re financially savvy, then you can likely invest and manage to build an emergency fund at the same time.
I chose to build my emergency fund inside of a Betterment “Safety Net” goal so I could have the best of both worlds. It has its risks, but I reached my savings goals faster and have enjoyed around a much higher return on my savings than if I had kept it in a bank account.
Should I Put an Emergency Fund in a CD?
I don’t think it’s a good idea, simply because CD rates already aren’t that great, and you’re effectively locking your money up. Sure, you can get your cash out by paying the penalty, but that’s not ideal. Additionally, you must move the funds to an account you can access. I deal with these similar issues with my Betterment “Safety Net” goal, except I don’t pay the penalty, and I get a much higher return on my investment than a CD.