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 savings fund.
What Is an Emergency Savings Fund?
An emergency fund is a liquid savings fund that covers large, unexpected expenses. It’s usually held in cash, but can also contain highly liquid cash equivalents like short-term Treasury bonds.
A “full” emergency fund should be large enough to cover at least 3 months of expenses. Many people prefer funds large enough to cover 6 or 9 months of expenses. If you have irregular income or you don’t have a full-time W-2 job, a 12-month emergency fund could be appropriate.
Whatever its size, your emergency fund is an important component of your personal risk management plan. It complements your retirement savings, goal-based savings, and various type of insurance coverage, including but not limited to:
- Health insurance
- Home insurance (whether homeowners insurance or renters insurance)
- Car insurance
- Life insurance
- Long-term disability insurance
To see how your emergency fund fits into your broader risk management plan, 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 9 months of living expenses. Your emergency fund covers your health care deductible, copays, and the other 3 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.
What Counts as an Emergency Savings Fund?
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.
How Much Emergency Savings Do You Need?
The short answer? It depends.
Historically, the rule of thumb was to save 3 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 3 and 6 months’ living expenses in cash, and sometimes as much as 12 months’ living expenses, depending on the stability of their income and expenses.
For instance, someone with an extremely secure job they’ve worked for 20 years, with a consistent W-2 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 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 6months of expenditures (or more) 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 big recurring expenses like your:
- Mortgage or rent payments
- Car loan payments
- Insurance premiums
- Childcare or tuition
- Fixed debt payments other than your mortgage and car note, such as student loan, personal loan, and home equity loan payments
But also variable expenses like:
- Utility payments
- Transportation expenses, such as fuel and transit fares
- Car and home maintenance
If you don’t have any emergency savings at all, start by saving up $1,000 as your highest financial priority without pausing on paying down unsecured debts.
Once you reach that milestone, take stock of how long it has taken you and how many (if any) sacrifices you’ve needed to make along the way. If you can comfortably save more each month, now’s the time to branch out and set up other goal-oriented savings buckets for larger or longer-term goals that don’t qualify as emergencies, such as vacation, car and/or home maintenance, a new car, and even budgetary line items like dining out or pet care.
But don’t stop (or even slow) your emergency fund contributions until you’ve reached your target expense coverage.
Where Should You Keep Your Emergency Fund?
Traditionally, people keep their emergency funds in savings accounts for easy access. We recommend a high-yield savings account, such as a CIT Bank Savings Builder account.
But a savings account isn’t the only place to hold emergency cash. In fact, once your emergency fund gets going, keeping it all in a single savings account isn’t always wise.
Personally, I keep a series of financial defenses, like tiers in a medieval castle. If this idea appeals to you, consider the following layers to your emergency fund.
1. 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 up to 2 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. But make sure you have a checking account at that bank so you can transfer the funds internally and have them available for use the same day.
2. Treasury Bonds or Funds
I keep some money in Treasury bond funds and a TIPS fund as extremely stable and safe investments. 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 2 and 6 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 the cash 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.
Given these drawbacks, Treasury bonds or funds — while useful — should represent only one element of your broader risk management strategy, not your whole emergency fund.
3. 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 3 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.
4. 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.
5. 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.
For what it’s worth, you can also use your HSA as a secondary retirement account. In fact, HSAs offer the best tax perks of any tax-sheltered account.
6. Roth IRA
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.
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?