An emergency fund is the term given to your savings account that acts as a resource to provide you with income during emergencies. Over time, you are building an emergency fund to get it to the amount that you need to live off of should an emergency arise. Emergencies include needing a new hot water heater, paying the deductible on your automobile policy after an accident, etc.
Emergency funds are also used to allow you to meet your monthly obligations (pay your bills) should you lose your job. Therefore, building an emergency fund up is essential in order to cover these situations. In an ideal world, you will never touch your emergency fund. However, the world is far from ideal.
Building An Emergency Fund
Why Build An Emergency Fund?
You know that an emergency fund will help you get through tough financial times, but is having one really necessary? The simple answer is yes! Think about your life if you were to lose your job. It would be pretty stressful right? Just the shock alone would be tough to handle. Now add in the additional stress of trying to find a job that pays just as well. But we aren’t done adding in the stress. Think about all of your bills every month you have to pay – water, electric, rent or mortgage. How are you going to cover these?
Some might look to their credit cards. This is a bad idea. Well, at first it might not seem so bad. You have the available credit to help you out. But as time goes on, this is just another bill you have to pay back. And the kicker is that you have to pay the original amount plus interest. Suddenly you aren’t just paying your electric bill, you are paying your electric bill and 20% more because of the interest. As you put more onto your credit card, you simply speed of the debt cycle and create an entirely different world of hurt.
This is why you need an emergency fund. It helps to take one piece of the stress pie out of the equation. When you have money set aside for tough times, you can focus all of your attention on finding a new job, not worrying about how to pay your bills.
I can attest to this personally. Back in 2013, I was laid off. It came out of the blue. The company was doing well and everyone at my place of employment was talking about how well of a job I was doing. But on that Tuesday morning, the owner called me into his office and told me the news. I was stunned. It was 2 months before my wife and I were getting married.
The reality didn’t really set in until a day or two later. Fortunately for us, we had a fully funded emergency fund. With the stress of trying to find a new job and finalizing wedding and honeymoon plans, I couldn’t begin to imagine life financially had we not had money set aside.
What Should The Size of Your Emergency Fund Be?
Many financial experts recommend building an emergency fund to 3-6 months worth of your monthly expenses. So if your monthly expenses are roughly $2,000 per month, your emergency fund should contain between $6,000 and $12,000. I feel that this amount is too conservative. The reason is because if you lose your job, there is a chance you will not find a replacement that pays as well as your old job in 3-6 months. What happens in months 7, 8 or 9? Where is the money coming from? Many will resort to using their credit cards to get by. As I mentioned earlier, this is a bad idea. By doing this, you are creating more headaches down the road.
To avoid this, I recommend building an emergency fund to 6-12 months of your living expenses. Using our hypothetical $2,000 expenses per month figure above, this means you need between $12,000 and $24,000 in an emergency fund. I realize this amount seems high. But you will be grateful when you have it saved. You will have peace of mind that should the unthinkable happen, you are in good shape for a year.
How To Build An Emergency Fund Size
Now, you may be thinking how do I go about building an emergency fund to one year’s worth of expenses? There are numerous ways to build up your emergency fund. Before I mention the ways, I want to point out that I am not telling you to completely change your way of life just to build up your emergency fund. Keep living your life. Just cut back a little here and there. The money will add up. Here are a handful of ways for building an emergency fund:
Create a Budget:
If you don’t have a budget, you need to create one. Doing so will allow you to see where you are spending your money and will help you spend it smartly. I know what many of you are thinking: the idea of creating a budget sounds painful. It really isn’t. I use Power Wallet. It’s a free tool that you can access online and on the go. Once you create a free account, you link your bank account and categorize a few things and you are done. Then you only have to log in to the account to see how you are spending your money. (If you prefer a more “hands on” approach, a free excel spreadsheet might be the way to go.)
Most people fail at saving because they are trying to save what is left after they spend their money. The problem with this idea is that most people spend everything they have so there is nothing left to save. Reverse this by saving first. Set up an automatic transfer from your checking account to your savings account for $20 a month. With the money getting transferred automatically, you will never miss it and your emergency fund will grow.
In addition to this, use Digit to help you save. They analyze your spending and income and make small transfers (less than $5 at time) to a savings account. By transferring so little, you never notice it is missing. I’ve been using them for most of this year and have saved over $500. You can sign up for the free service here or read more about them in this post. (Yearly Savings: $300+)
Revise Your Budget:
If you are spending $150 month dining out, cut it back to $100-125 and set up an auto transfer to your emergency fund for the $25-50. See if you can reduce your cable package and save some money there. There are numerous areas to cut back and by looking over your budget and making small tweaks here and there, you can easily find additional savings. (Yearly Savings: $300-$600)
Transfer Savings to Savings:
When you go shopping, look at the bottom of your receipt. Most likely there will be listed the amount you saved. Take that “savings” and transfer it to your emergency fund. I only do this for my grocery shopping and transfer a healthy bit of money over the course of a year. (Yearly Savings: $1,000)
I use 2 pieces of technology when I shop – receipt hog and Ebates. Receipt hog is an app on my phone. I take a picture of my receipt with the app and get coins or spins (basically chances to win more coins). After I collect a certain amount of coins, I redeem them for cash in my PayPal account. To sign up for Receipt Hog for free, click here. If you use my referral code: skiv8225, you’ll earn bonus spins for a chance to win more coins after you submit your first receipt.
Ebates is an online shopping portal. You can read all about them in this post, but basically by going to a retailer through the Ebates website, you earn cash back. Every quarter, Ebates sends you a check or puts the money in your PayPal account. You can sign up for Ebates here.
By doing both of these, you can save an extra $100 or more to put towards your emergency fund.
Save a Portion of Your Tax Refund:
If you get a tax refund each year, take a set percentage of it and transfer it to your emergency fund. Since most look at a tax refund as “extra money”, you should be saving a healthy portion of it and using a small portion for spending. This assumes you have all of your high interest debts paid off. (Yearly Savings: $400 – this assumes the average refund and you are still paying down credit card debt.)
If you get a raise, ignore it. Take out your last paycheck prior to the raise and compare it to your new paycheck. Find the difference and set up a transfer to move that amount from your checking account to your emergency fund each time you get paid. You’ve been living off your old salary, so you can do it for a little while longer. (Yearly Savings: $1,000)
Save Your Change:
You should be paying for most everything in cash. When you come home from a shopping trip, take all of your loose change from your pocket and put it in a jar. Each month, take the jar, count the coins, and deposit that amount into your emergency fund. Note: Many banks offer free coin counting. Under no circumstance should you pay to have your coins counted! (Yearly Savings: $225)
Where To Build Your Emergency Fund
Where should you build your emergency fund? Ideally, you want your emergency cash in liquid accounts, such as savings accounts and bank certificates of deposit (CD’s). Even if you do have some of your emergency fund in CD’s, there should still be a decent amount (at least $5,000) in a savings account. This way you can quickly access it, whereas with CD’s or other short term investments you have to go to the bank or broker and pull the money out. This process will add at least a day or two until you have access to your cash.
I know what you are thinking, with interest rates so low, you think you should be investing your emergency fund to earn some decent interest. This is the exact wrong thing to do! You have to remember what the point of the emergency fund is. It is designed to get you through tough times financially. It is not designed to allow you to retire. The last thing you should be concerned with is earning a high interest rate on this money. Risk and return are related and you want the least possible risk.
If you have to invest some of this money, follow this rule of thumb:
- Keep $5,000 in cash in a savings account
- Put the rest in short term bonds
Understand that the money in the bond fund can lose money. Bonds are not risk free and do lose value. But if you must invest, they are your best option. And with interest rates so low, you are probably better just keeping your money in cash. We use the Capital One 360 savings account (formerly ING Direct). We earn 0.75% and while not a lot, we know our money is safe and we can get to it relatively easy. And to help you earn a greater return, use this referral code. By using this code and funding your account with $250, you will earn a $25 bonus. That is basically a 10% return on your money!
Keeping Track of Your Emergency Fund
One tool I love to use to keep track of my financial accounts (banking, investing, credit cards, etc.) is with Personal Capital. It is a free account aggregator (think Mint.com) that pulls all your financial information into one place. I like it more than Mint.com because 1) it works. With Mint, I would have to relink my accounts just about every time I logged in. And, 2) it does an incredible job with my investments by showing me my allocation and the fees I am paying. To, me it is definitely worth a look. Best of all, it is 100% free.
Building an emergency fund is critical to your financial well-being. It will help you to avoid going into credit card debt to get by financially. It will also help you to avoid the stress that comes with knowing you can’t pay the important bills to put food on the table and keep a roof over your family’s head.
While the amount you need to completely fund your emergency fund may be overwhelming, know that the process is simple and painless as I pointed out above. As you build yours, focus on just getting to a balance of $500 and then $1,000. This will keep you motivated to push through and fund the account entirely. And as the size of the account grows, so too will the monthly interest you earn as well.
Heck, just these 8 tips I noted in this post will net you over $4,000 in your emergency fund in one year. This would be on top of what you are saving monthly. And, these are only 8 tips! In my eBook, Spare Change, I list hundreds of other ways to boost your emergency fund savings.
You have to build an emergency fund. Not only will it provide the safety net you need should something happen, it also provides for a solid foundation so you can better save for retirement and save in general.
Readers, how did you go about building an emergency fund?