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How to Start & Build Up Your Emergency Fund in Savings

Unexpected costs hit you all the time. From hefty car repair bills to medical emergencies, job losses to furloughs, emergencies are a matter of “when,” not “if.”

You have a choice: you can either prepare for them in advance, or you can let them plunge you into panic every time one comes along.

If you’re ready to stop living paycheck to paycheck, start building your emergency fund.

What Is an Emergency Fund?

Your emergency fund exists to cover large, unexpected expenses. Expenses you couldn’t just swallow by cutting out the restaurant meals this month.

Traditionally, people hold their emergency funds in savings accounts for easy access. But that’s not the only way to hold emergency funds (more on that shortly).

An emergency fund also exists to give you peace of mind.

Your money sits ready on standby, so to speak, just waiting to be called into action. You don’t have to scramble to come up with the money you need, and you don’t have to rack up huge debts.

Even if your emergency fund can’t cover everything, it can still reduce the money you have to borrow from friends and family or credit cards.

What Constitutes an Emergency?

Your emergency fund isn’t a slush fund for large entertainment and leisure purposes. A new high-def TV doesn’t qualify as an emergency, even if your old TV breaks down.

Raiding your emergency fund for nonemergencies defeats the entire purpose. A true emergency is a situation that requires some sort of immediate action and that can affect your long-term well-being or impact the viability of a critical asset, such as your home.

A few situations that constitute true emergencies include:

  • A Large Deductible or Copay on a Health Emergency. You don’t want empty pockets to get in the way of proper medical care. Enough said.
  • Large and Unexpected Home Repairs or Deductibles. Insurance doesn’t cover every repair, and your home will inevitably need ongoing updates, maintenance, and replacements from the roof to the flooring.
  • Major Car Repairs. This includes paying your deductible for damages caused by a car accident or replacing busted parts in your engine. Routine car maintenance, however, should be scheduled into your monthly budget.
  • Emergency Travel. This includes travel necessitated by a family emergency, such as a death in the family.
  • The Failure of a Major Appliance. If your furnace or fridge suddenly stops working, you may need to pay for a replacement quickly.

You should never tap your emergency savings for predictable expenses like annual insurance premiums, holiday or birthday gifts, shower gifts, down payments, or leisure travel. You need other types of savings for these irregular nonemergency expenses.

Part of a Larger Risk Management Plan

Life is full of risk. You can’t (and shouldn’t) avoid every risk, but rather manage your risk.

Your emergency fund constitutes one part of your risk management plan. But it’s not your only tool in managing risk.

You should also maintain insurance policies to protect against risk. Two insurance policies everyone should have at all times include health insurance and home insurance (whether homeowners insurance or renters insurance).

Depending on your unique circumstances, you may also need car insurance, life insurance, long-term disability insurance, and any of a hundred other types of policies.

Imagine a scenario where you get hit by a hit-and-run driver. You rack up some enormous medical bills and are unable to work for the next year while you recover.

Your medical insurance covers most of your hospital and physical therapy bills, and let’s say your disability insurance covers nine months of living expenses. Your emergency fund covers your health care deductible, copays, and the other three months of living expenses.

Now imagine what would happen if you didn’t have an emergency fund. Or, for that matter, insurance. You’d scramble desperately for money — just when you are least able to do so.


How Much Emergency Savings Do I Need?

The short answer? It depends.

Historically, the rule of thumb was to save three months of expenses as a safety net. But no two people’s financial situations are the same, and some people need more money than others.

The more stable your income and expenses, the less money you need in your emergency fund.

Average middle-class Americans need between two and six months’ living expenses in cash, and sometimes as much as 12 months’ living expenses, depending on the stability of your income and expenses.

For instance, someone with an extremely secure job they’ve worked for 20 years, with a consistent W2 salary, doesn’t need as much in emergency savings as a freelancer whose income fluctuates month to month.

Likewise, someone with the exact same bills month in and month out doesn’t need as much emergency savings as someone with variable living expenses from one month to the next.

If you don’t have any emergency savings, start by saving up $1,000 as your highest financial priority. Once you reach that milestone, you can start putting money toward paying down unsecured debts before growing your emergency fund to its full strength.

If you aren’t sure exactly what you’re spending each month, it’s time to create a budget and start tracking your spending against it. You can also review the past six months of expenditures if you’ve been using personal finance software, such as Tiller or Personal Capital, or a debit or credit card that tracks expenses.

Make sure you include not just recurring expenses like your mortgage and car loans, but also variable expenses like utilities, groceries, and other essential expenditures. Don’t forget expenses that only come due once or a few times per year, such as car insurance premiums.

Check out Dave Ramsey’s Baby Steps as a reasonable way to prioritize your financial goals. As you build wealth and financial literacy, you can customize your financial planning more, but start simple.


How to Hold Your Emergency Fund

You could hold your entire emergency fund in a high-yield savings account, such as a CIT Bank Savings Builder account.

But the idea of so much cash sitting around and earning so little just rubs me the wrong way. Instead, I keep a series of financial defenses, like tiers in a medieval castle.

If the idea appeals to you, consider the following layers to your emergency fund.

Cash Savings

You do need some cash that you can easily yank from a regular savings account or money market account. You never know when you’ll need access to cash today, right now, no questions asked.

I keep between one and two months’ worth of expenses in an FDIC-insured bank account, ready to be tapped at a moment’s notice. Consider using a different bank than you use for checking, perhaps an online bank, to keep your rainy day fund out of sight and out of mind.

Treasury Bonds or Funds

I keep some money in Treasury bond funds and a TIPS fund as extremely stable and safe investments. But being exchange-traded funds (ETFs), they’re also extremely liquid: I can sell them instantly in my brokerage account.

You can also buy and sell bonds directly with your brokerage account if you prefer.

In my case, I hold between two and six months’ worth of living expenses in these funds. Sometimes I hold additional money in them temporarily while waiting on a longer-term investment opportunity, such as a piece of real estate, to come along.

But these relatively safe investments still represent a deeper layer of defense. You can’t access instantly — if an emergency hits you on a Friday evening, financial markets won’t open again until Monday morning for you to sell your shares or bonds.

Even after selling, you can’t just pull your cash balance from your brokerage account out of an ATM. You need to transfer it to your checking account, which can take several days in itself.

Again, they represent one element of a larger risk management strategy, not my whole emergency fund.

CD Ladders

Some people also create a certificate of deposit (CD) ladder as part of their emergency fund.

You can create a CD ladder by purchasing multiple CDs such that one expires every month, every three months, or at any other interval of your choosing.

This way, you know when the money will become available — and should you need to access the money unexpectedly, you only lose the interest on one CD, as opposed to all of them.

A CD ladder allows you to access the higher yields that only accompany longer-term CDs. However, a CD ladder should only make up a portion of your long-term emergency fund so you can avoid any penalties associated with early withdrawal.

Unused Low-Interest Credit Cards

My wife and I use travel reward credit cards in our everyday lives and pay them in full each month. But we also keep low-APR credit cards in reserve, untouched, as a final emergency fallback.

These can, for example, hold us over for a few days while we sell off shares in a TIPS fund and transfer money from our brokerage account to our checking account. They offer one more layer of defense, with instant accessibility.

Credit cards aren’t convenient for pulling out cash, given high cash advance fees and low cash advance limits. But they’re extremely convenient for emergency purchases, such as a last-minute flight home for a family health emergency.

Health Savings Accounts (HSAs)

If you have a high-deductible health care plan, you can and should build a health savings account(HSA) to complement it.

You can use your HSA savings toward your deductible, of course. But you can also use it for other health-related expenses, such as dentistry, eyeglasses, contact lenses, fertility costs, birth control, mental health treatment, and any other conceivably health-related expenses. See IRS Publication 502 for the complete list of eligible expenses.

You can also use your HSA as a secondary retirement account. In fact, HSAs offer the best tax perks of any tax-sheltered account.

Roth IRAs

As a last defense, a Roth IRA can bail you out of a true financial collapse.

The IRS allows you to withdraw contributions from your Roth IRA tax-free and penalty-free at any age. But once withdrawn, it stops compounding for you in the background and building your nest egg.

Take advantage of Roth IRA contributions, intending them as retirement investments but knowing you can tap into them if a dire catastrophe strikes.


Tips for Building Your Emergency Fund Faster

The idea of saving months’ worth of living expenses feels daunting for many middle-class Americans.

As outlined above, start with a goal of just $1,000. When you reach it, pause and pay off your unsecured debts. Eliminating those payments will free up more money for savings, and you can then turn your attention back to your emergency fund.

At that point, consider splitting your savings between your emergency fund and your investments. Take advantage of employer matching contributions toward your retirement account. Invest through your Roth IRA and HSA accounts, which can both double as emergency sources of capital.

Don’t lose sleep over the pace of your emergency savings. Just get started and remain consistent so that over time, you can reach your emergency fund goal.

Try these tips for effectively building your emergency fund.

1. Break It Down

Decide how much you want in your emergency fund and figure out how much you can put in each month. Then, determine how long it will take to reach your target based on your monthly contribution.

Breaking it down this way can make saving for your emergency fund and other goals more manageable.

2. Make It Automatic

Schedule regular transfers from your checking account to your emergency fund using automatic savings tools.

Talk to your HR department about splitting a portion of your paycheck to direct deposit into your emergency savings account. You can try tools like Chime Bank’s automated savings as well.

Automate it once, so you don’t have to rely on discipline each month to make it happen.

3. Use “Wasted” Money

Some estimates indicate that each household wastes at least 10% of its income each month. Look for the money leaks in your budget, such as over-ordering at restaurants or leaving the lights on when you’re not in a room. Plug these leaks, and then use that money to build up your emergency fund.

4. Pad Your Fund With Dividend Earnings

Dividend stocks aren’t just for income investing. You can also use them to pad your emergency fund. Build a portfolio that includes dividend stocks, and deposit those dividends in your emergency fund.

It isn’t the fastest way to fund your emergency account, though, so make sure you’re saving in other ways as well.

5. Use Spare Change

Have your entire family empty the change from their pockets, perhaps including their one- and five-dollar bills, into a jar at the end of each day. At the end of each month, take the money in the jar and add it to your emergency fund. Or use an automated tool like Acorns that rounds up every purchase you make and saves or invests the difference.

Again, use this technique to supplement or boost your emergency fund, but don’t depend on it entirely to get you to your goal.

6. Set Aside Your Tax Refund

You could blow your tax refund on that new TV — or you could put it toward your emergency fund and potentially meet your savings goal in one move.

7. Celebrate Milestones

Keep track of your financial goals and mark special achievements.

Obviously, you don’t want to splurge big, but when you reach a milestone, reward yourself with a small treat such as a night at the movies or a new book. Even cooking a fun celebratory dinner at home can mark the occasion and motivate you to keep going.


Final Word

An emergency fund can mean the difference between financial failure and financial success. It prepares you for unexpected setbacks and reduces your dependence on borrowing money, most likely at high interest rates.

Start with a clear understanding of your monthly living expenses, and then set a goal for how many months you want to be able to cover with your emergency fund.

From there, you can decide what portion of your savings should go toward your emergency fund, and what you want to invest elsewhere.

Most of all, avoid raiding your emergency fund for nonemergencies. Otherwise, what’s the point of having one at all?

G. Brian Davis
G. Brian Davis is a real estate investor, personal finance writer, and travel addict mildly obsessed with FIRE. He spends nine months of the year in Abu Dhabi, and splits the rest of the year between his hometown of Baltimore and traveling the world.

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