The COVID-19 pandemic was a major wake-up call to many investors, proving that emergencies can come out of nowhere when they are least expected. As all too many people learned the hard way this year, a healthy emergency fund can make all the difference in the world.
Early in 2020, when job loss and layoffs started happening, many people didn’t have enough money to cover basic expenses like car payments and food bills. Instead, they were forced to wait for government stimulus checks to come in. And for many, those checks were not enough.
As the pandemic proved, not having an emergency fund can be dangerous. According to one study, just 41% of Americans would be able to cover a $1,000 emergency with savings — and that was before COVID-19.
The good news is that by putting together an emergency fund that covers at least a months’ worth of your expenses, you’ll be much better positioned to overcome unforeseen financial challenges that may come your way.
What is an Emergency Fund?
An emergency fund — or rainy day fund — is a special stash of cash that you stock away specifically to cover unexpected expenses. For example, you might use an emergency fund to cover car repairs after an accident or to cover living expenses after a job loss or illness rears its ugly head.
Since it’s essentially like insurance against the curveballs life will throw at you, putting together an emergency fund is one of the smartest financial decisions you can make in life.
How to Start an Emergency Fund
Having an emergency fund is one of the most important personal finance decisions to make in life — right up there with budgeting and retirement planning.
Here’s my simple 4-step process as to how you can start building your emergency fund today.
1. Set a Budget
Start by doing some basic budgeting to figure out your cash flow and monthly expenses. A budget can serve as a financial roadmap, helping you determine how much money you can safely allocate for various accounts.
For example, suppose you have an average monthly income of $3,000. Of this, $1,200 may go to rent, $600 toward food, $150 to utilities, and $100 to debt payments, like student loans or credit cards. This leaves you with $900 leftover to spend, save, and invest freely. You can use some of that cash to seed your emergency fund.
Forming a budget is easy. If you need help, consider using a service like You Need a Budget (YNAB).
YNAB helps you save money and get a handle on your finances. Get started today, risk-free, with their 34 day free trial.
2. Open an Emergency Account
Once you have a basic idea of your budget, the next step is to set up a separate bank account dedicated entirely to emergency savings.
By opening a separate account, you’ll be able to leave your emergency fund alone and draw upon it if and when you need it.
As you begin thinking about where to park your emergency fund, here are some options you’ll want to consider.
Checking accounts typically offer very low interest rates, hovering near 0.05%. However, they offer flexibility to move money around as needed without facing any transaction limits. Savings accounts, on the other hand, restrict the amount of transactions you can make on a monthly basis.
Money Market Account
A money market is an interest-bearing account offering the flexibility of a checking or savings account but with a higher interest rate. You can typically write a limited number of checks against your money market account each month.
High-Yield Savings Account
A high-yield savings account (HYSA) is an online savings account with interest rates that run roughly 20 times more than traditional checking or savings accounts.
You can access an HYSA from a company like American Express, Marcus by Goldman Sachs, Barclays Bank, and countless others. Because they offer high interest rates compared to other accounts and are insured by the FDIC, an HYSA is an ideal vehicle for an emergency fund for many investors.
3. Invest for Growth
In addition to short-term savings, you’ll also want to start investing for long-term growth. The reason for this is simple: The more money you set aside now, the less planning you’ll have to do as you get older.
Young investors should put money into long-term retirement accounts like individual retirement accounts (IRAs), Roth IRAs, and 401ks. You may also want to explore using a Health Savings Account (HSA) if you are eligible. In addition to offering tax benefits, these savings accounts collect compound interest over time, giving you significantly more when you retire. You can also invest your HSA funds in the stock market for additional gains.
4. Use An Emergency Fund Calculator
Now that you have a plan in place, the next step is to figure out how much money you should have stored away. Check out the Millennial Money Emergency Fund Calculator below to learn how much is right for you.
Why You Need an Emergency Fund
Cover Basic Expenses
Simply put, an emergency fund can be used to cover basic expenses when income ceases for a prolonged period of time or when unexpected events occur (e.g., you break your leg). An emergency fund can be used to fund a limited budget for basic necessities like food, shelter, utilities, and fuel. It can also be used to pay for medical bills or other accidents.
It’s a good idea to link your emergency fund with a checking account or set up a money market account for quick and easy access through a debit card.
As a rule of thumb, you should strive to have a minimum of at least six months’ worth of expenses in your emergency fund. This is a savings goal that everyone should strive for.
Avoid Financial Setbacks
Having an emergency fund can help you stay afloat without throwing your other financial goals too far off track. It can prevent you from liquidating investments or selling assets like a car or your home to survive during a difficult time. It can also keep you from racking up credit card debt unnecessarily.
The thing to remember is that a financial emergency can quickly go from bad to worse if you’re not careful. Build an emergency fund to serve as a safety net that protects you from unexpected emergencies. This is the best way to emerge from a crisis unscathed.
Pay Health Bills
An emergency fund can also be used to pay for unexpected medical bills.
Medical debt from healthcare bills is one of the top economic pitfalls for consumers. Lengthy hospital stays, ambulance rides, and medication or therapy can cost tens of thousands of dollars if you’re not prepared. Estimates are that between a quarter and a half of all bankruptcies involve significant medical expenses. If you set aside money ahead of time, you are going to be in a better position to pay for care when it’s needed.
Tips for Building an Emergency Fund
One of the downsides to using an HYSA is that interest rates can fluctuate depending on the state of the economy. It can be tempting to put your money into a certificate of deposit (CD) to lock in a higher interest rate for a period of time.
Putting emergency savings into a CD can be dangerous because it can lock your money up for several months or years, restricting you from accessing it without penalty when you’re in a pinch.
Avoid Tapping into Savings
Maintaining an emergency fund can require lots of discipline. Having excess money on hand can make it easy to overspend, knowing that you have large cash reserves available to cover several months of expenses.
Tapping into savings is a slippery slope. What starts as $20 or $50 here or there could quickly add up, depleting your hard-earned savings and leaving little left over to cover emergencies.
If you’re struggling to fund your emergency fund, consider using your tax refund or money you get for your birthday to start. It might not be the most glamorous way to spend your money. But you’ll thank yourself if you ever need to cover any emergency expenses.
Continue to Fund the Account
One pitfall that consumers make with emergency savings accounts is that they fail to keep funding them. Instead, they reach a certain threshold and then stop, thinking that their work is done.
The problem with this approach is that your lifestyle can change over time. For example, you may get a raise, buy a house, or start a family. All of a sudden, the $10,000 that you have in savings is going to seem like a lot less.
The better approach is to continuously and automatically fund the account using direct deposit, adjusting the amount you put in to suit your lifestyle. When you reach a certain threshold, move the money into a higher-earning or more secure account like a CD or index fund. This way, your emergency account can continue to provide enough for your needs as they evolve over time.
Frequently Asked Questions
When should you use emergency savings?
Emergency savings should be used only during an actual emergency situation — like if you lose your job and are having trouble accessing unemployment or if you get sick and don’t have insurance to cover your costs.
You should also use emergency savings before you tap into credit cards or cash out on any investments, like savings bonds, stocks, or mutual funds. Those should be used as last-resort options in a financial emergency.
Should you use retirement savings for emergencies?
Using retirement savings from a 401k account or IRA is generally not a good idea. First of all, accessing retirement funds before retirement can come with a stiff financial penalty. What’s more, you’ll also have to pay taxes on any money that you take out of retirement. And even worse, you can quickly burn through years of retirement planning, turning a short-term financial emergency into a personal financial catastrophe.
The best approach is to treat that money like it doesn’t exist and focus on other ways to plan for emergencies. Diversify your income to bring in more cash than you can set aside, and put money into high-performing savings accounts and the stock market.
Should you put emergency savings in the stock market?
One of the best ways to plan for emergency savings is to put six months of savings in a secure account. This can be accomplished using CDs, an HYSA, or a checking or savings account.
Since the stock market is much more volatile than secure savings accounts, you definitely do not want to put your emergency fund there. Don’t invest money you can’t afford to lose. Whenever you put money into the stock market, make sure you have enough cash in savings to cover emergency expenses.
You can invest your emergency fund if you’re strategic about it, but it’s important to understand the risks.
How can you prevent tapping into emergency savings?
Diversify your income to avoid tapping into emergency savings during a situation where you lose your income. One way to do this is to start a side hustle or a side gig. By doing so, you will expand your sources of income, which can help reduce the risk of losing your job.
Making money on the side should make it easier for you to fund your emergency savings account. At the same time, it can also prevent you from depleting your emergency savings when you fall on hard times.
The Bottom Line
Life is unpredictable. At some point, you may find yourself in a situation where you are unable to bring in money for whatever reason. You might also find yourself facing an unforeseen expense you didn’t budget for.
By starting an emergency fund and linking it to your bank account, you can get the peace of mind that comes with knowing you have a safety net to help you cover short-term expenses during an emergency situation.
Remember: It’s vital to share with your future self. It can be hard to look down the road and plan for an emergency. But by doing so, you’ll be in a much better position to deal with a stressful situation when it happens.
At the end of the day, financial security is all about planning ahead. By starting an emergency fund, you will be much better off down the line. And once your fund is squared away, you can start thinking about other ways to invest your money and achieve financial independence.