Unexpected expenses always seem to catch you off guard. From car repair costs to medical expenses, from job loss to sudden van emergencies—when they strike, they can be overwhelming.
You have a choice: you can either prepare for them in advance or let them stress you out each time they arise.
If you’re ready to break free from living paycheck to paycheck, start establishing your emergency savings fund.
What Is An Emergency Savings Fund?
An emergency fund is a readily accessible savings fund meant to cover significant, unforeseen expenses. It’s typically held in cash but might also include highly liquid cash equivalents such as short-term Treasury bonds.
A “full” emergency fund should be substantial enough to cover at least three months of expenses. Many people prefer funds large enough to cover six or nine months of expenses. In cases of irregular income or incomplete W-2 work, a 12-month emergency fund might be more suitable.
Regardless of its size, your emergency fund is a critical component of your personal risk management plan. It complements your retirement savings, targeted savings, and various types of insurance coverage, including but not limited to:
- Health insurance
- Home insurance (either homeowners insurance or renters insurance)
- Car insurance
- Life insurance
- Long-term disability insurance
To comprehend how your emergency fund integrates into your broader risk management plan, envision a scenario where you’re involved in a hit-and-run accident. You incur substantial medical bills and are unable to work for the following year as you recover.
While your health insurance covers most of your hospital and physical therapy expenses, your disability insurance covers nine months of living expenses. Your emergency fund steps in to cover the remaining medical expenses, copays, and an additional three months of living expenses.
Now, consider the potential outcome if you lack an emergency fund or insurance coverage. You would do your best to earn money, but the financial impact could be significantly more challenging to manage.
What Does The Emergency Savings Fund Count For?
Your emergency fund serves as a safety net for significant fun and relaxation purposes. A new high-end TV doesn’t constitute an emergency, even if your old one breaks.
Your emergency fund defeats the entire purpose of being reserved for genuine emergencies. A true emergency is one that necessitates immediate action and can impact your long-term well-being or the affordability of a critical asset, such as your home.
Several situations that qualify as true emergencies are:
- Large Deductible or Copay for a Health Emergency: You don’t want empty pockets hindering proper medical care.
- Large and Unexpected Home Repairs or Deductibles: Insurance doesn’t cover every repair. Your home will undoubtedly require constant renovations, repairs, and replacements from the roof to the floor.
- Essential Vehicle Repair: This encompasses paying your deductible for damage caused by a car accident or replacing damaged parts in your engine. Car repairs should be factored into your monthly budget.
- Urgent Travel: This includes necessary travel during a family emergency, such as a death in the family.
- Major Appliance Failure: If your furnace or refrigerator suddenly stops working, you may need to quickly pay for a replacement.
You should never have to dip into your emergency savings for unforeseen expenses, such as annual insurance premiums, holiday or birthday gifts, shower gifts, down payments, or vacation travel. Other types of savings are required for these irregular non-emergency expenses.
How Much Emergency Savings Do You Need?
The short answer to this question? It depends.
Historically, the rule of thumb was to save 3 months of expenses as a safety net. However, no two people’s financial situations are the same. Some individuals need more money than others.
The more stable your income and expenses, the less money you require in your emergency fund.
Middle-class Americans typically need 3-6 months of living expenses in cash, and sometimes 12 months of living expenses, depending on the stability of their income and expenses.
For instance, someone with 20 years of extremely secure employment and consistent W-2 paychecks doesn’t need as much emergency savings as a freelancer whose income fluctuates monthly.
Likewise, someone with consistent monthly expenses doesn’t need as much emergency savings as someone whose living expenses vary each month.
If you’re unsure of your monthly expenses, it’s time to create a budget and start tracking your expenditures. You can review expenses from the past 6 months or more using a personal finance program like Tiller or Personal Capital, or a debit/credit card that tracks expenses.
Ensure that you include only large recurring expenses such as:
- Mortgage or rent payments
- Car loan payments
- Insurance costs
- Education or childcare expenses
- Fixed debt payments besides your mortgage and car loan, such as student loans, personal loans, or home equity loan payments
Variable costs also encompass:
- Utility payments
- Food expenses
- Transportation costs like fuel and transit fares
- Car and home repairs
If you lack emergency savings, start by prioritizing saving $1 as your top financial goal without pausing to pay off uninsured debts.
Once you achieve that milestone, consider how long it took and what sacrifices (if any) you had to make. If you can save more each month, it’s time to diversify and establish other savings buckets for larger or longer-term goals that do not qualify as emergencies. For example, budget items like vacations, car and home repairs, a new car, or even food or pet care.
However, don’t halt or decrease your contributions to your emergency fund until you reach your targeted spending range.
Where Should You Kep Your Emergency Fund?
Typically, people store their emergency funds in savings. We recommend a high-yield savings account, such as the UFB Direct High Yield Savings account.
However, a savings account isn’t the sole place to keep emergency cash. In fact, it’s not always wise to keep it all in one savings account once your emergency fund is depleted.
Personally, I maintain a system of protective layers akin to those in a medieval castle. If this concept resonates with you, consider the following layers for your emergency fund:
1. Cash Reserves
You need readily accessible funds that can be withdrawn easily from a regular savings account or a money market account. You never know when immediate access to cash might be necessary. Currently, no questions are asked.
I maintain up to 2 months’ worth of expenses in an FDIC-insured bank account, ready to be accessed at a moment’s notice. Consider using a reputable, possibly online bank to stash your rainy-day fund out of sight and out of mind. However, ensure you have a checking account with that bank to facilitate transferring funds in and having them available for immediate use.
2. Treasury Bills or Funds
I allocate a portion of my funds to treasury bond funds and a TIPS (Treasury Inflation-Protected Securities) fund, regarded as extremely stable and secure investments. As exchange-traded funds (ETFs), they are highly liquid, allowing for immediate sale in my brokerage account.
Alternatively, you can directly buy and sell bonds using your brokerage account.
In my practice, I reserve 2-6 months of living expenses in these funds. Occasionally, I temporarily hold extra cash in them while awaiting a long-term investment opportunity, such as a real estate purchase.
However, these relatively secure investments serve as an additional layer of protection. They do not provide instant access to cash. If an emergency arises on a Thursday, financial markets won’t reopen until Monday morning for you to sell your stocks or bonds.
Even after the sale, you can’t simply withdraw your cash balance from your brokerage account via an ATM. It must be transferred to your checking account, a process that might take several days.
Given these constraints, although beneficial, bonds or treasuries should only constitute a part of your broader risk management strategy, not your entire emergency fund.
3. CD Ladders
Some individuals construct a ladder of certificates of deposit (CDs) as part of an emergency fund.
You can build a CD ladder by purchasing CDs that mature at monthly, quarterly, or any other interval you choose.
This strategy ensures the predetermined availability of funds. In case of an unforeseen withdrawal, you forfeit only the interest on a single CD, not the entire sum.
However, the CD ladder should form only a portion of your long-term emergency fund to avoid any penalties associated with early withdrawals.
4. Unused Low-Interest Credit Cards
My spouse and I use travel rewards credit cards for daily expenses, paying them off in full each month. Nevertheless, we reserve low-APR credit cards as a final resort in emergencies.
These cards can sustain us temporarily while we sell assets like TIPS shares and transfer funds from our brokerage account to our checking account. They offer an added layer of security with instant availability.
Credit cards are not ideal for cash withdrawals due to high cash advance fees and limited cash advance limits. Nevertheless, they prove extremely useful for urgent purchases, such as last-minute flights during a family health emergency.
5. Health Savings Accounts (HSAs)
If you possess a high-deductible health care plan, it’s advisable to establish and build a health savings account (HSA) to supplement it.
Your HSA savings can be utilized to cover your deductible, but they’re also applicable for various other health-related expenses, including dental care, eyewear, fertility treatments, contraceptives, mental health services, and any other conceivable health-related costs. Refer to IRS Publication 502 for a complete list of eligible expenses.
Moreover, your HSA can serve as a secondary retirement account, offering excellent tax advantages.
6. Roth IRA
As a final safety net, a Roth IRA can serve as a lifeline during a severe financial crisis.
The IRS permits tax-free and penalty-free withdrawals of contributions from a Roth IRA at any age. However, once withdrawn, these funds cease to accrue interest, impacting the growth of your retirement savings.
While initially intended as retirement investments, take advantage of Roth IRA contributions knowing they can be tapped into in dire circumstances.
In conclusion, within the realm of emergency preparedness, the difference between financial ruin and success is implicit. Establishing an emergency fund equips you to face unexpected challenges and lessens reliance on borrowed funds, potentially reducing financial vulnerability by a significant margin.
Begin by clearly assessing your monthly living expenses. Then, set a target for the number of months you wish to have covered in case of emergencies.
Subsequently, determine the portion of your savings designated for the emergency fund and allocate the rest elsewhere for investment purposes.
Most importantly, refrain from depleting your emergency fund needlessly. Otherwise, it defeats the purpose of having one in the first place.