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Building an emergency fund needs to be one of your core personal finance goals. Unemployment, serious medical problems, divorce and other unexpected life emergencies can all crop up at the worst possible times — and when they do, you’ll be ready for them if you have a well-stocked emergency fund. In this guide, we’ll explain how to build an emergency fund, how much you need in your fund, where to keep it, and when to use it.
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An emergency fund is a sum of money that you set aside to pay for serious, unexpected financial emergencies. Your emergency fund helps you avoid relying on expensive forms of debt, like personal loans or credit cards. While you can’t always anticipate the unexpected, you can prepare by having an emergency fund ready to go.
An emergency fund should be reserved for major, unplanned situations that could disrupt your life. The costs incurred in these situations stem from serious, longer-term events. Some common scenarios could include:
Note that an emergency fund is different from a rainy day fund. A rainy day fund is meant to handle smaller one-off expenses that are somewhat predictable, such as routine home maintenance, broken appliances, last-minute travel expenses or the like. You would expect to be paying expenses out of a rainy-day fund with a certain regularity, several times a year.
Your emergency fund needs to be something you hope you never have to use. Think of an emergency fund as more of an insurance policy than a supplement to your regular budget.
Deciding how much you should save for an emergency fund isn’t a one-size-fits-all answer. A good rule of thumb, however, is to cover your financial needs for a set amount of time based on your income and living expenses. The amount that’s best for you will depend on your individual circumstances.
For example, a single-income family of four will likely have different financial needs than a dual-income family of two, as would a person with a full-time job and someone who’s self-employed. Consider these different months-of-income size funds.
If you are single and have a steady job, saving three months worth of your income can work well. You only have yourself to worry about, so it’s only your living expenses that will need to be covered, rather than those of a spouse or children. This size fund can also work for a dual-income family that can rely on a single income in case one person suffers a job loss.
Those who have a spouse and children will likely need to save more money than those who are independent. Six months should cover the costs for those who are married with a stable income and have young children living with them, especially if the household has a single earner. This size fund is also recommended if someone in the family has a chronic medical condition that can incur frequent visits to the doctor or hospital.
Anyone who is self-employed or has infrequent income, such as a freelancer or commission-only salesperson, can benefit by saving more than those who have a stable income — nine months is a good go-to target. This way you’re able to pay for any unexpected emergency as well as the loss of a client or project or a lull in income.
Whether your account should hold three months worth of expenses or more, saving money for an emergency fund can seem daunting, especially when you are first starting out. Just like any form of saving, though, you can use a few easy strategies to help build your momentum and your balance.
There are three key factors to keep in mind when choosing an account in which to keep your emergency fund: liquidity, yield and security. Liquidity means ease of access to your money: you should be able to get cash out of your emergency fund on very short notice. To maximize growth of the money you have saved, you’ll want a competitive interest rate on the account. And security means there’s little chance you’ll lose any money on your investment.
Taking liquidity and yield into account means that some accounts are better choices than others to hold your emergency fund. When it comes to security, it’s best to consider deposit accounts insured by the Federal Deposit Insurance Corporation (FDIC) up to the legal limit. Let’s take a look at four deposit account options: cash management accounts, savings accounts, money market accounts and certificates of deposit (CDs).
Cash management accounts typically combine the higher yielding interest rates of some savings accounts and CDs with the convenient liquidity of a checking account. This makes them an ideal account type for your emergency fund.
The best high-yield savings accounts pay a high rate of interest, making them a good place to keep an emergency fund. Money market accounts are a type of savings account that offers attractive interest rates, but typically require a relatively high minimum balance to earn interest. It’s not hard to find money market accounts and saving accounts that come with debit cards and even checks, providing better access to your emergency fund. One thing to be aware of: the Federal Reserve’s Regulation D limits “convenient” withdrawals — such ATM transactions — in savings and money market accounts to six a month.
CDs are term deposit accounts where it’s possible to get an attractive rate of interest, in exchange for agreeing not to withdraw your money for a certain period of time. You may close a CD and get your money back at any point in its term if you need to, but you generally will give up some or all of your earned interest as a penalty.
This factor makes CDs a less attractive choice for your emergency fund. Possible ways to mitigate this include using no-penalty CDs or building a CD ladder. No-penalty CDs usually have lower interest rates than conventional CDs, but you may make either partial withdrawals or withdraw the entire amount at any time over the course of the CD’s term penalty free. With a CD ladder, opening CDs of different terms provides you with a predictably stream of maturing CD income, although this is still a lower level of liquidity than other deposit account types.
A savings account can be a good option for an emergency fund because there are many options that pay decent rates of interest, they’re relatively liquid accounts, and they carry FDIC insurance. Your best bet when looking for a savings account is to check out online banks. Find an account with an ATM card or check writing privileges.
Here’s a good rule of thumb to decide if an expense is an emergency: Ask yourself whether it’s unplanned and uncontrollable. True emergencies that are both unplanned and uncontrollable are things that materially impact your health, wellbeing or ability to earn a living.
One-time expenses like a great deal on a vacation package, that big-ticket gift you’d love to get your spouse, or paying for sleepaway camp for your kids are all the opposite of emergencies. Deciding how to pay for things like this, no matter how expensive, is part of your regular budget planning process.
Regular expenses that are not surprises, such as paying your property taxes or insurance on your car or home, are not emergencies. These bills may be large, but at the end of the day they are predictable expenses that should be part of your regular budget planning process.
Losing your job to a layoff or coming down with a life-threatening disease are the very definition of emergencies. These are the reasons you have an emergency fund: Peace of mind for the worst that life can throw at you.