You’ve probably heard tips on creating an emergency fund either online or from friends and family.
The concept is an essential part of everyone’s personal finances. But that doesn’t mean everyone understands the most effective way to build their emergency fund.
Common misconceptions about the emergency fund include:
How much should be in your emergency fund
What to use your emergency fund on
How to build it
Where to build it
After reading this article, you’ll know how much you should have in your emergency fund and you’ll have a plan on how to get there.
First, let’s make sure we’re on the same page and talk about what an emergency fund is and isn’t.
What exactly is an emergency fund? And how is it different from a savings account?
An emergency fund is what it sounds like - a portion of cash set aside for unplanned expenses.
But don’t mistake an emergency fund for a savings account or money set aside for Christmas.
In the world of personal finance, it's wisest to assign all of your money to specific tasks.
For example, you can save a specific amount of money for your future wedding, a house, or college.
But those dollars shouldn’t touch your emergency fund. With an emergency fund, you’re allocating a specific portion of your savings to financial emergencies.
Some examples of financial emergencies include:
Unplanned periods of unemployment
Sudden vehicle expenses
Why do I need an emergency fund?
Without a cushion set aside, a financial emergency can have a negative ripple effect on other areas of your finances like your credit score or investment plans.
If you’re proactive about your financial emergencies, it will be easier for you to focus on other financial goals like paying off debt or investing consistently.
An emergency fund is an essential part of every person’s financial plan. Some other reasons you to have an emergency fund that you may not have thought about include:
If you only have one source of income
If you’re self-employed
If you own a home
If you’re saving for a big goal
How much do I need in my emergency fund?
How much you need in your emergency fund is going to be different per person. But a common rule of thumb is to save 3-6 months of basic living expenses.
But wait, there’s more.
Something that isn’t addressed often is that three and six months are actually two very different numbers when it comes to living expenses.
So how do you know which one you should aim for?
Generally, three months of living expenses refers to those with salaried positions and more job security.
And six months refers to those who have contract or temporary positions.
The point is to build up your emergency fund during your high-income periods to prepare for periods where your income won’t be efficient enough to fund your emergency.
Understanding how much you need in your emergency fund is the easy part.
But what's the most efficient way to reach your goal?
Should you just stop buying coffee and avocado toast as the finance gurus say? Should you just put it all in at once? Where do you even put your funds?
This might seem simple, but let’s dive deeper together to make sure we’re building our emergency fund in the most effective way possible.
Tips on building your emergency fund
Plan your emergency fund
When planning your finances, you never want to think something like, “I want a bunch of money in my emergency fund.” You will see better results if you’re intentional about every step of the way.
So, if your goal is to have three months' worth of expenses in your emergency fund, first aim for one month’s worth. Then two, and so on until you reach your ultimate goal.
Planning for small steps makes the journey fun and reachable.
Start with small increments
Choose a small percentage of your income that won’t change your lifestyle. Something like $10 - $100 out of your take-home pay per month so you won’t get discouraged from making regular contributions.
Build a habit out of it and strategize so it doesn’t become a hassle.
Automate your savings
Speaking of hassles, you can make your contribution process even easier through automated savings.
You can choose to put your savings in a savings account that allows you to make contributions without you having to check your balance every month.
Just like the stock market, you want to set yourself up so you don’t have to check your account every day.
Don’t overdo it
The cool part about an emergency fund is that it's designed to relieve you of any financial stress.
So in addition to giving you a financial cushion, you can also stop making contributions once you’ve reached your 3-6 months' worth of funds.
Decide where to build your emergency fund
Some great places to build your emergency fund include:
High-yield savings account
Money market account
Traditional savings account
Certificate of deposit
All of these accounts have something called an annual percentage yield (APY). This means your emergency fund can grow by itself over time and keep up with inflation or even keep up with your lifestyle as you upgrade over time.
A good rule of thumb when deciding where to build your emergency fund is to contribute where you can access it quickly. For example, you can’t withdraw from your 401K, but you can withdraw from your Roth IRA as long as you aren’t taking from your earnings from investments.
And with high-yield savings accounts, you usually can’t access them directly. But you can link them to your bank account so you can transfer the funds within a few days.
But also consider that you don’t want your emergency fund to be too convenient to access so you’re not tempted to use the funds for a vacation or something that it's not intended for.
Now you have an understanding of how much you need in your emergency fund and the steps to build one.
Your next step is to figure out where you want to build your emergency fund, create a new savings account if necessary, and begin your contribution plan.
Creating an emergency fund is a straightforward process but that doesn’t mean you won’t make mistakes.
Remember, your emergency fund is not your retirement savings or money set aside for your future house, or that vacation to Europe.
In the personal finance world, your money is most effective if you assign each dollar to a specific role.
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