What is an Emergency Fund?
Whether it’s COVID-19, a flooded basement, or car repairs, emergencies can come in all shapes and sizes. They have the potential to impact anyone and often come with financial repercussions. An emergency fund acts as a way to weather these unforeseeable events and their inevitable expenses. By creating a financial safety net, you’ll be able to manage unexpected finances while maintaining your financial health and avoiding debt.
In this Wealth Rocket guide, we’ll take a look at what an emergency fund is, how it works, how to build one, and steps to avoid in the process.
Definition: emergency fund
An emergency fund is a financial safety net for life’s unpredictable moments. Think of it as a rainy-day fund. A leading reason to build and eventually use an emergency fund is only for emergency situations, which can include:
- Unexpected job loss
- Medical expenses
- Urgent car repairs
- Major home repairs
Money in an emergency fund is set aside, built over time, and should be instantly accessible in the event of an emergency.
An fund for emergencies also acts as a buffer. It aims to offer peace of mind from financial stress while providing the comfort of having money set aside for unexpected expenses. It should also help you avoid going into debt when you face unexpected expenses.
Finally, an emergency fund should help you pay for things you can’t live without. That means rent, groceries, and transportation, not clothes, a vacation, or a new console.
How much should I keep in an emergency fund?
There is no definitive amount of money that should be set aside in an emergency fund. There are some guidelines and recommendations on a suitable amount, however.
A sweet spot for an emergency fund amount should cover your expenses from three months to one year.
If you don’t have a lot of money saved yet, don’t worry! Aiming for a minimum of $500 to $1,000 to get started and build it up as you go along is a great place to get started.
The major takeaway here is to have a comfortable amount of money saved to cover your expenses in the case of an unexpected life event.
The larger the emergency fund, the more expenses it can cover. Keep in mind, it’ll also take longer to build.
How to build an emergency fund
Building an emergency fund is simpler than it sounds. All it takes is simple budgeting, time, and consistency.
Below, you’ll find a step-by-step approach to building an emergency savings account that can help you in the event of unexpected expenses.
1. Regularly set aside a small portion of your income
The easiest way to start building an emergency fund is by regularly setting aside a portion of your income.
While this might seem daunting at first, planning and staying consistency will make it an easy process. These things take time, so don’t get discouraged.
The amount you’ll set aside differs from person to person. It depends on how much you’ll earn, personal budgets, and personal expenses. After all, everyone has a different financial situation.
You may also want to consider cutting or minimizing expenses, if possible (such as that daily coffee run or pausing a few subscriptions), and putting the money saved right into your emergency fund.
An excellent threshold is trying to save at least 10% of your monthly income for future use. A smaller percent is also acceptable, but it will take longer to build.
Naturally, a higher percentage would build an emergency fund faster, but it's important to take these steps one day at a time and make them work with you and your expenses.
2. Choose the right bank account
Money in an emergency fund should be accessible at a moment's notice. Ideally, you wouldn't want to keep your money in a chequing or investing account, as a chequing account does not earn interest and elevates the temptation to spend. In contrast, investing accounts are most suitable for long-term, big picture saving goals like purchasing a home or retirement.
A high-yield savings account with an interest rate that beats inflation is ideal for keeping an emergency fund. Your money remains liquid while earning some interest.
If you have a hard time saving, often finding yourself picking at your savings, you might want to consider opening an account with another bank. Many online banks do not charge monthly or annual fees and often issue great interest rates. They're also usually insured and accessible through your mobile phone.
Where you should not keep an emergency fund
First and foremost, you should always keep your emergency savings in a safe place, most notably at a bank or credit union where your money is insured and protected.
Do not keep your savings in cash stored under the mattress or any other number of hidden locations around your house. Doing this is usually unsafe and difficult to reclaim if it’s stolen or damaged.
Investments are a great place to keep your money for the long-term but not for an emergency fund. While investments can beat inflation and usually come with great returns, emergency funds require you to withdraw your money at a moment’s notice. You won’t want to liquidate your assets if they aren’t performing well.
Frequently Asked Questions
Not to be the bearer of bad news, but your emergency fund savings are not for vacations. In fact, it isn't for any planned purchases, regardless of how expensive they are.
Savings in an emergency fund are for financial stability during unexpected emergencies and urgent situations. Things like a car accident, a trip to the emergency room, job loss, or a sudden illness.
These are examples of unexpected life events. Your emergency fund is a rainy day. It would be best if you only dipped into it for the sole purpose of keeping you and your finances afloat.
Since there are various types of debts, whether you should start saving or paying off debt depends on the type of debt you currently have.
Paying off high-interest debt, such as credit card debt or loans, should always be a priority over saving, as these types of debt can become quite costly in the long-run.
You'll typically want to tackle the debt with the highest interest rate first. Some exceptions apply, however. Major debts with stable interest rates, such as student loans, car loans, or a mortgage, can receive the minimum payment if you intend to save money and build an emergency fund.
Of course, having no debt at all is always the best scenario. But, if you're looking to start saving some money, aim to save at least $1,000 towards your emergency fund. Once you've built an adequate safety net, you can return to paying any remaining debts.
Of course! Everyone needs an emergency fund. While it is common for young people not to worry about their savings, that doesn't mean they shouldn't start building an emergency fund. After all, emergencies do not discriminate and can happen at any time.
It may be daunting for students who already have many expenses to start an emergency fund. However, by starting small, saving what you can, and focusing on one month at a time, your savings will start growing, and your future self will thank you.