How to Start an Emergency Fund
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Most experts would agree - starting an emergency fund is a critical step in managing your personal finances. Without a solid emergency fund, you (and your family) could be at risk for financial ruin in the event of a job loss, medical emergency, or something worse.
If you are just getting started in adulthood or haven’t paid much attention to your finances, then you may be asking yourself - What is an emergency fund and how do I start one?
Emergency funds are typically made up of cash in a savings account that you can access at anytime … such as in the case of an “emergency”.
This type of account should be separate from your normal savings account that would be used to help buy a car, pay your monthly utility bills, or go on a vacation.
Instead, these are funds that can be used to prevent potential bankruptcy in the event of unforeseen expenses (like loss of employment).
It is up to you to decide what is an emergency and what is just an unexpected part of life that costs you money.
Now that we know what an emergency fund is … let’s learn how to actually start and build one.
But first, we need to answer some commonly asked questions about emergency funds that hopefully can give you a clearer picture of just how important this pile of cash can be.
Commonly Asked Questions About an Emergency Fund
Before we get too far along learning how to start an emergency fund, let’s tackle some important questions you may have.
What is an Emergency Fund Used For?
The answer to this may seem simple, but it really depends on what you consider an emergency.
Here at The Money Sprout, we believe emergency funds should be used to help prevent a catastrophic financial disaster … such as bankruptcy.
For example, let’s assume you are a single income family (or just a single working person living on your own).
What would happen if you unexpectedly lost your job and had no other income streams to cover your monthly expenses?
Would you be able to pay your mortgage? Buy food for your family and be able to pay to keep the heat and power on in your home?
An emergency fund should be used in this situation to avoid things like losing heat in your home or racking up a bunch of credit card debt to pay your bills.
On the other hand, using your emergency fund to help pay for going over budget on your Christmas holiday shopping is not really a good idea. You should probably just not overspend in the first place … I know that is easier said than done.
Ultimately, you and your family will have to decide what an emergency fund should be used for.
Where Should I Put My Emergency Fund?
Now that we know what an emergency fund should be used for, let’s explore where you should put it.
This decision is up to you, but our suggestion is to build your emergency fund someplace that is safe and where you can easily get to it.
For example, putting your emergency fund in a speculative investment like cryptocurrency would not be a good idea. Nor would investing it in the stock market or real estate.
We don’t want our emergency fund assets to go down in value in case we need to use them … like in an emergency. So cryptocurrency is an awful place to build your emergency fund.
Actually, the stock market (while great for building net worth) is also a bad place for emergency fund assets.
What if you suddenly needed money to pay for an unexpected medical expense? And let’s also say at this same time, our economy is going through a recession … which likely means the stock market is down in value.
An emergency fund that is invested in stocks could quickly lose value in this scenario which makes it a bad fit … not to mention you can’t access the dollars immediately.
The same goes with real estate. An emergency fund needs to be liquid (meaning you can get to it quickly) and real estate investments are anything but liquid assets.
So where should you put your emergency fund? Our best suggestion is a high-yield savings account that earns some interest.
There are some other options you could use to build an emergency fund like certificates of deposit, but those have some drawbacks as well.
We think it is best to keep it simple and park your emergency fund in an online savings account like Ally Bank or CIT Bank.
We’d also suggest once you pick a savings account for your emergency fund, don’t waste your time chasing small yield changes. The difference between earning 2.0% and 1.80% on even $50,000 is only a savings of $100 annually. We think there are much better uses of your time.
How Much Money Should you Have in an Emergency Fund?
Okay, so now for the question that everyone wants to know - how much money should you have in an emergency fund?
The amount of money that you should put into an emergency fund will vary widely between individuals and couples.
For example, a single person with little debt may not need very much in their emergency fund compared to a married couple with 3 kids living on a single income with a mortgage and car payments.
Ultimately the amount of money to put away into an emergency fund should depend on your own unique circumstances.
Most financial gurus recommend anywhere from 3 months of expenses up to an entire year … and everything in between. Take a look at these suggestions from well known financial experts -
- Dave Ramsey recommends having 6 months of expenses saved in an emergency fund
- Suze Orman recommends having at least 8 months of expenses in an emergency fund
Here at The Money Sprout, we recommend anywhere between 3 to 6 months of living expenses should be sitting in an emergency fund. Those assets should be earning some interest in a high yield savings account.
Anything more than 6 months of living expenses could be invested into an asset that would generate more wealth compared to a high interest savings account. Certificates of Deposit (CD’s), passive index funds, or even blue chip dividend stocks are a few examples.
Personally, my wife and I try to keep 6 months of living expenses saved up in our emergency fund in an Ally Savings account.
This account is separate from all of our other accounts (i.e. checking). We’ve also made it just a little bit harder to access these funds since they are in a savings account instead of checking.
I will admit that this is a very conservative approach to building an emergency fund and one we may someday change.
Emergency Fund Yield
At the time of this writing our emergency fund was earning 1.80% interest in our savings account. Over the past year this account has fluctuated anywhere from 1.80% to 2.10% APY (annual percentage yield).
And by the way … we don’t waste our time chasing higher yields at similar banks. Unless something drastic changes in the online savings account we are using (right now it is Ally) … then we will make things simpler and keep it there.
7 Steps to Start an Emergency fund
Now that we know what an emergency fund is and answered some common questions you may have had about them, let’s look at how you can build yours.
We’ve broken down how to start an emergency fund into 7 simple steps. We like simplicity in life and especially with managing our finances.
Hopefully these are easy for you to follow along with and get started down your path of securing your financial future by building an emergency fund.
1 - Calculate Your Monthly Expenses
The first step is that you need to know how much you spend every month. For those who already know how much they spend each month … feel free to move on to step #2.
If you don’t know this, then take the time to start tracking your expenses for the last 6 to 12 months. We suggest 12 months in order to include any annual expenses like homeowners insurance or property taxes on a home.
Once you’ve determined your annual spending, take the amount that you spent over the past year and divide it by 12. The result will be the average amount of money you spend each month.
For example, if you spent $60,000 last year, then your monthly average would be $5,000 ($60,000 / 12 = $5,000).
Obviously, if you can only get the past 6 months then dividend that total by 6. This is a good starting point at least to get started and you can adjust accordingly over time.
But if you only can track your spending for the past 6 months … make sure to continue tracking your spending for the next 6 months. That way you will have a more accurate picture of spending over an entire year.
For my wife and I, we have been tracking our annual spending for the past 3 years. Overall, we averaged around $60,000 of expenses annually … which is the number we use to calculate our monthly expenses.
As you likely have already figured out … our monthly average expenses total - $5,000.
2 - Figure Out How Many Months You Want to Save (and then calculate your amount)
This very well could be the most critical step in starting an emergency fund.
How many months of expenses do you want to save up in an emergency fund? Remember that most experts recommend having funds available to cover 3 to 12 months of expenses at any given time.
So what is best for you? Well … that is something only you and your family can decide.
But we’d suggest that the more people relying on your income from a job for their own well being … the more emergency fund you should have built up.
For example, my wife and I are raising our family off of a single income. Granted it is a good income, but if it were to go away tomorrow … we’d need to tap into some emergency funds rather quickly. Therefore, we chose to build up at least 6 months of expenses in our emergency fund.
On the other hand, a two income household may be able to get by with only 3 months worth of emergency funds. Or someone who is single that only needs to provide for themselves may only need 3 months as well.
It comes down to your comfort and risk level in how many months you want to save for. Our family has chosen to build up 6 months of expenses and we’ve considered at times to bump it up to 9 or 12 months.
So by saving up 6 months worth of expenses, we know we would need to have an emergency fund with an approximately value of $30,000.
This simple calculation takes 6 months of expenses x $5,000 monthly expenses to equal the $30,000.
Overall, we feel a good range to shoot for is somewhere between 3 to 12 months of expenses built up in your emergency fund.
3 - Open an Online High Yield Savings Account
The next step is to research where you plan to start an emergency fund. As we have mentioned earlier, an online high yield savings account probably makes the most sense.
You won’t earn a ton of interest on your emergency fund, but it is better than nothing. You would probably build more wealth by putting your emergency fund into the stock market or even real estate. But then that would be defeating the purpose of an emergency fund in the first place.
Our family’s emergency fund was built in a separate online savings account away from our regular checking accounts (we have two of those). These funds are not touched (unless in an emergency) and currently earn us between 1.80% and 2.0% APY.
At the time of this writing, a $30,000 emergency fund balance earns our family between $550 to $600 in interest per year.
While there are many choices for opening an online high yield savings account, our two preferences are Ally Bank or CIT Bank.
4 - Keep it Separate from all Your Other Accounts
This didn’t need to necessarily be a step all on it’s own … but it is very important so we broke it out.
Don’t mix and match your regular savings and checking accounts with your emergency fund savings account!
Does it really matter if you mix accounts? Not one bit to be honest, but are you disciplined enough to leave your emergency funds alone? I highly doubt it.
This is why my wife and I choose to setup a separate Ally savings account that is used only for our emergency fund. There is no temptation to use the balance for other expenses. We leave it alone and let if earn a little bit of interest every year.
We also sleep a little better knowing it is there at any point when we would desperately need it.
If you decide to combine all your savings and checking into one bank account, then be prepared to keep detailed records and have lots of discipline to protect your emergency fund.
And if you decide to keep all your savings and disposable income in a checking account … be ready to earn almost nothing on it (around 0.1% at the time of this writing).
5 - Setup Monthly Automated Deposits
Now comes the time to start putting money into your emergency fund.
While you certainly could deposit the entire amount, we highly doubt you would be in a position to do that right away. It took my wife and I several years to build up an emergency fund of $30,000.
The next best choice for building the balance in your emergency fund is by setting up automated monthly deposits from your checking account. It doesn’t have to be a ton of money at first, but the sooner you start the better.
Overtime you can increase your monthly deposits higher as you adjust your spending.
When my wife and I were building our emergency fund, it was at a time when we had two incomes and no children. So we decided to live off of one of our incomes, while putting 100% of the other into our emergency fund until hitting our goal.
The path we picked to live off of one income and fund our emergency savings with the other income is another option. It certainly accelerated our timeline in building our emergency fund.
I will say that we have used the monthly automated deposits to readjust our emergency fund balance a few times. We have had to use a portion of our emergency funds on a few occasions. In order to bring the balance back up, we set up automated deposits which really helped us hit our goals.
Get started now with deposits to your emergency fund … no matter how small.
6 - Always Adjust Your Savings
So maybe you took our advice and started to fund your emergency with automated monthly deposits? And even though you may only be depositing $25 or $50 a month, you got started and are making some progress.
But then a few months or years go by and life changes. Let’s say you get a raise at work. What are you planning to do with that extra income?
Our advice is simple … take that entire amount of extra income you are earning each month and throw it at your emergency fund. Keep doing this until you hit your goal.
Or what about your tax refund you are set to get? Why not take that and deposit it in your emergency fund?
You need a way to get ahead and these are the types of situations that can help you reach your goals sooner.
Like in our example above, my wife and I took advantage of having no kids and two incomes with relatively low expenses … we took as much as we could each month and put it towards our emergency fund.
We suggest to always adjust your savings to an emergency fund upwards to help hit your goals.
And guess what? Once you hit those goals of fully funding your emergency fund … you can move on to the next step … which is where we start to build wealth.
7 - Always Keep Investing
At some point you are going to hit your emergency fund goals (hopefully), so our suggestion is to keep that momentum rolling and continue to save … only this time much more aggressively.
If you have already created a habit of funding your emergency fund each month, it is a great idea to continue sending the same amount to a brokerage account (or some other investment) when you’ve hit your goals.
We will leave it to you for what you decide to invest in after your emergency fund is where you want it.
My wife and I choose to fund our Roth IRA accounts anytime we aren’t working to build back up our emergency fund. Then once those are full, we continue investing as much as we can into taxable brokerage accounts.
Some may decide to save up for a rental property investment. Or maybe some want to invest in starting a business to build wealth.
There are a lot of options to build wealth (once your emergency fund is set) … but the key is to continue the momentum you started in the first 6 steps of starting your emergency fund.
For next steps, we suggest checking out our content on investing.
Starting an Emergency Fund
As you can probably tell by now, we feel that starting an emergency fund is one of the most important financial decisions you can make.
Having a solid savings of available cash can be critical in unexpected financial emergencies. Thing like the loss of a job or unexpected medical bills can really wreak havoc on your finances.
That is where having an emergency fund can really help avoid things like credit card debt or even bankruptcy.
Starting an emergency fund won’t happen overnight, but it isn’t to hard to build as long as you have a plan and follow it.
So what are you waiting for? Take the steps today to start protecting you and your family from financial hardship by starting an emergency fund.
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