Emergency funds may not be the most exciting topic in the world of personal finance, but it certainly is one of the most important aspects of your financial life.
In fact, when I was in college, I took a finance course that was taught by a Certified Financial Planner. His #1 piece of advice for us students was to start an emergency fund.
He placed the emergency fund at a higher priority than paying off student loan debts, saving for a first home, or any other financial goal.
Regardless of your financial situation, you need to have a plan in place for an emergency, one that involves setting some money aside specifically for an emergency.
What Is An Emergency Fund?
An emergency fund is money that you have saved to be used in case of an unexpected emergency. When you’re creating your budget or financial plan, you don’t have the luxury of knowing what the future holds, so it’s important to be prepared for something that isn’t expected.
The need for an emergency fund may be more obvious now than ever before. With millions of Americans being furloughed or laid off as a result of COVID-19, and millions more concerned about the future, the need for financial preparation has become obvious.
On the topic of emergency funds, it’s also equally important to define what an emergency fund is not intended to cover. It should be used only for true emergencies that could not be anticipated, not simply for irregular expenses that could have been anticipated.
For example, you shouldn’t tap into your emergency fund because you need to buy a wedding gift for a friend and that expense wasn’t included in your budget. This may not be an expense that regularly occurs every month, but you can still budget for gifts.
And likewise, you shouldn’t use your emergency fund to pay for an annual car inspection since you know that expense will be coming.
Your emergency fund could be kept in a number of different types of accounts. The most important thing is that it can be liquidated and turned into cash very quickly. Later on in the article, we’ll take a more detailed look at the types of accounts you can use for your own emergency fund.
Why You Need An Emergency Fund
If an emergency fund sounds like something that might not be necessary, here are some convincing reasons why you should make it a priority.
1. Be Prepared For Unexpected Expenses
Life is full of unexpected events, and some of them can wind up costing a lot of money. This could include things like unexpected repairs to your car, urgent and unplanned home repairs, and even damage from natural disasters (which may or may not be covered by insurance).
These unexpected expenses can be big in some cases, and if you’re not prepared, it can ruin the plans that you’d created.
2. Protect Against A Loss Of Income
None of us want to think about losing our jobs or experiencing a significant drop in income, but unfortunately it’s a pretty common issue and it can have very serious consequences with your finances.
What would you do if you were to lose your job today? How would you pay your bills and living expenses? One of the reasons why you need an emergency fund is to be able to survive a situation like this.
If you were to lose your job, ideally, you’ll be able to collect unemployment. But that’s not always the case, and your unemployment payments may be a lot lower than the income that you’re used to. It’s best to be prepared and have money set aside to cover for a situation like this.
3. Unpredictable Income
Losing your job isn’t the only threat to your income. Maybe you have an inconsistent income and your emergency fund could be used to help out if your income is unexpectedly low for a while.
An emergency fund is even more important if you don’t have a set salary from your job. If you’re self-employed, you own a business, or you’re paid on commission, you’re more likely to experience a drop in income at some point.
Later on in the article, we’ll take a look at how much money you should have in your emergency fund, but if you’re self-employed, you should probably be on the higher end of the scale since you’re at a greater risk.
4. Single Income
If all of your income is from one source, you’re at a greater risk than someone with multiple sources of income. If that single source of income disappears, you’ll have no income at all.
This can also be impacted by your family status. If you’re single, there’s a greater chance that you have only a single income. If you have a family, you’re more likely to have two incomes. Dual-income families, in general, face a slightly lower risk than single-income families because if one income is lost, there’s still some money coming in.
This is another factor that can influence the amount of money you should have saved in your emergency fund.
5. Avoid Debt
If you have no emergency fund, what will you do in the case of an expected expense or a drop in income? Chances are, you’ll have to rely on debt.
Credit cards and personal loans are often used essentially as an emergency fund, but these types of debt come with sky-high interest rates and the debt can be difficult to pay off.
On the other hand, if you have an emergency fund in place, you can avoid the debt since you’ll already have the money set aside. Of course, you’ll want to work to replace that money in the emergency fund, but at least you’ve avoided debt and significant interest rates that may prevent you from ever being able to get ahead.
6. Medical Concerns
Another type of unexpected issue that we don’t like to talk about relates to medical concerns. Again, this is something that, unfortunately, happens to people all the time.
Even if you have medical insurance, you could be left with some significant bills to pay. It doesn’t take very much to rack up large medical bills.
The emergency fund is especially important if you or someone in your family has medical issues that are likely to lead to expenses at some point. While medical emergencies can happen to anyone, they’re more likely from someone with pre-existing conditions.
The medical concerns of you and your family should be kept in mind when you’re deciding how much money to save for an emergency fund.
Are you single or do you have others who depend on you? While an emergency fund is important for singles, it’s even more important for anyone with family members that need to be supported.
Your dependents are most likely your kids, but it’s also possible that you have aging parents or other family members that depend on you financially. The more responsibility you have, the greater your need to be prepared for an emergency.
If you’re single, you may have an easier time replacing your income, or at least covering your basic living expenses, if you were to lose your job. But covering living expenses can be much harder when you’re providing for others as well.
8. Improved Financial Health
If you’re looking to improve your overall financial situation, being prepared for an emergency can help. You could be great with budgeting, avoiding debt, and saving for retirement. But all of that can change in an instant with an unexpected emergency.
Without an emergency fund, you may rack up credit card debt, deplete your savings, or even borrow from your retirement accounts. All of these things can be extremely damaging to your long-term finances, so it’s easy to see why it pays to be prepared.
9. Peace Of Mind
Aside from all of the financial reasons why you should be prepared for an emergency, it can also help your stress level. You’ll find that you worry about money a lot less when you have a sufficient emergency fund.
This also comes back to the risk factors that you face in your own life. When I was younger and single, I didn’t worry about money all that much. Now that I’m responsible for the only income for my family of four (and that income is unpredictable), money is on my mind all the time. I’ve found that having a sufficient emergency fund makes a huge difference for peace of mind.
How Much Money Should You Have In Your Emergency Fund?
When it comes to emergency funds, this is the most common question. Most experts recommend that you have enough money in an emergency fund to cover 3-6 months of living expenses. That means, if you or your family spends $5,000 per month, you should have $15,000 – $30,000 in an emergency fund.
If you’re just getting started with an emergency fund, that probably sounds like a lot of money. Don’t get discouraged. It’s ok to work towards that goal gradually. Even having a smaller emergency fund of $500 – $1,000 can make a big difference and help with smaller unexpected expenses.
If you don’t have anything in an emergency fund right now, set your goal at $500 and start making progress. Setting a goal like $30,000 can be overwhelming if you’re starting with nothing.
In reality, the amount that you should have in your emergency fund will be impacted by several different factors that influence your level of risk. Common risk factors include things like:
- Unpredictable income
- A family with dependents
- Single income
- Family members with medical needs
The more of these risk factors that apply to you, the more money you should have saved in your emergency fund. If none of these factors apply to you, it’s probably safer for you to be at the lower end of the scale.
What Type of Account Should You Use?
Many people keep their emergency fund in a savings account or money market account because:
- The money in these accounts can be accessed quickly and easily with no penalty
- There’s no risk of losing money in a bad investment
Online banks like CIT Bank, Axos Bank, and Radius Bank are ideal choices because they offer higher interest rates than most local banks, so at least you’ll be earning some interest on the money in your emergency fund.
While the safe route of using an online savings account or money market account can be a great option, it’s not the only option.
The most important detail is that you’re able to access the money quickly. Many people prefer to know that their emergency fund isn’t susceptible to risk of dropping in value, but some people don’t mind taking a little bit of risk with their emergency fund.
Investments like stocks, bonds, mutual funds, and ETFs also offer a great deal of liquidity, so it’s possible that you could use a brokerage account as your emergency fund.
The downside to this would be the fact that your emergency fund may drop in value and you may not have much of a choice as to when you sell the investments. You may be forced to sell when your investments are down because you need the cash.
But the upside is that you’ll have a chance to earn a much better return and build wealth faster than you could if your money was sitting in a savings account earning 1-2%.
If you’re ok accepting that risk, you could keep your emergency fund with:
What’s right for you will depend on your own risk tolerance, your financial goals, and your financial situation.
How To Save For Your Emergency Fund
To get money into your emergency fund, you can cut back on your normal expenses or increase your income through a side hustle. With either option, there’s other content here at Bible Money Matters that can help. Please refer to these articles:
- 20 Best Side Hustles to Make an Extra $500 per Month
- 17 Weekend Side Hustles to Make Extra Money on the Side
- 50 Easy Ways to Save Money Every Month
- 10 Weird and Unconventional Ways to Save Money