An emergency fund is an amount of savings set aside for unplanned expenses or financial emergencies. It’s important to be financially prepared for anything, and saving an emergency fund can provide you with peace of mind while helping you avoid debt.
Why set up an emergency fund?
It’s a usual practice to save money for large, planned purchases, such as a new car, house, vacation, or even a wedding. It makes sense to save money for unexpected purchases, too. Some common examples include:
- Car repairs
- Home repairs
- Unforeseen medical bills
If you find yourself in one of these situations, you’ll be glad to have an emergency fund to utilize, rather than turning to credit cards or high-interest loans. Particularly if you already have debt, it’s important to avoid borrowing even more money.
How to get started
The first step towards an emergency fund is to evaluate your finances to see how much you can afford to save. If you don’t already have a budget, now is the time to create one. Make a list of your monthly expenses and find the total. Then, compare the total to your monthly income to see how much money remains. This is the amount you can divide among your savings, investments, and disposable income.
The next step is to figure out your goal: How much should you save in your emergency fund? Saving enough money to cover between three to six months of essential expenses is the general rule, but you can adjust this number to any amount that makes you feel secure. Reference your monthly budget to figure out what three to six months of critical costs looks like for you—this does not include expenses like entertainment, which would be cut in the event of a major crisis. If the number seems daunting, remember that it’s okay to start small and work your way there. You can try setting an initial goal of anywhere from $500 to $1,000, then increasing that amount once you reach the benchmark. Even a small amount of emergency funds is better than having none at all.
Create a savings account for your emergency fund and decide on an amount of money you can regularly contribute. It may help to adjust your direct deposit to automatically deposit the money into your emergency fund, to ensure consistency and avoid the temptation to spend it. Consider adding other large funds you receive throughout the year to your emergency fund as well, such as a tax refund, holiday bonus, birthday gift, or even garage sale earnings.
Emergency fund maintenance
Check the account balance of your emergency fund frequently to monitor your progress. It’s prudent to track how much you’ve saved and make adjustments according to your goals and any changes in your income or monthly expenses. It can also be encouraging to watch your funds increase, to help motivate you to keep saving.
If you use your emergency fund at any point, start rebuilding it as soon as possible. You know now why it’s so important to have an emergency fund, so be sure to restart any automatic deposits that may have been interrupted and add additional funds when possible. Be patient as you restore your safety net, and remember that maintaining it will become easier over time with practice.
Benefits of an emergency fund
The biggest benefit of having an emergency fund is that it preserves your credit by helping you avoid debt, but there are plenty of other ways you can benefit from emergency savings. If you don’t have an emergency fund for unexpected costs, you could be forced to borrow from other sources, like friends, family, or your retirement fund. Knowing that you have an insurance policy against unplanned expenses can also help you stress less.
Common mistakes with emergency savings
One possible issue with an emergency fund is withdrawing money too often. It’s important to save these particular funds for true emergencies, like a large hospital fee or unemployment. You could also experience an income reduction from fewer hours or a salary cut, which is also a reasonable time to dip into your emergency fund. Other expenses like routine car maintenance, vacations, and holiday shopping, however, shouldn’t cause you to use these savings.
If you find yourself wondering whether too much money has accumulated in your emergency fund, consider adding the excess money to your retirement fund or investing it instead. While it’s never a bad thing to have extra money set aside for emergencies, that money could become a bigger help in an account with a higher rate of return.