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If you want to set your financial life up on a solid foundation, building an emergency fund is a good place to start. Life is unpredictable. But, it’s almost a certainty that there will be ups and downs, and an occasional bump in the road.
Setting up an emergency fund will help you navigate these inevitable bumps and prevent them from growing into a catastrophe. In this post, we’ll walk through how to build an emergency fund, and answer all sorts of related questions.
What Is An Emergency Fund?
An emergency fund is just what it sounds like. It’s a bank account that you maintain to make sure that you have enough money set aside to cover large unexpected expenses and financial issues that can come up out of nowhere.
Unexpected expenses include things like medical bills, car repairs, new appliances, home repairs, and other costs that you aren’t necessarily expecting. These types of expenses can be really tough to anticipate. No one plans to have a fender bender. But when it happens, you might be on the hook for thousands of dollars.
Emergency funds are also a source of cash in the event that you suddenly find yourself without any income. Maybe you get laid off from your job, and the unemployment benefits that you receive only cover a fraction of your living expenses for example.
Why Do You Need An Emergency Fund?
It’s important to maintain an emergency fund so that you’re prepared for the inevitable rainy day that comes along.
If you don’t have an emergency fund, and all of a sudden you find out that your house’s roof needs to be replaced, what are you going to do? Rack up thousands of dollars in credit card debt to replace it? Put off doing the replacement and potentially cause other damage to your home? These aren’t great options.
On the other hand, if you have an emergency fund set up, you can simply make a withdrawal to cover the cost of the roof. You might not like having to shell out for an expense like this. But, it won’t send you into a downward financial spiral.
How Much Should You Save?
Ok, so if you’re onboard with building an emergency fund, the next question is just how much you should save. The answer is that it really depends on your lifestyle and what your monthly expenses look like.
The general rule of thumb is that you want to save somewhere between three and six months worth of living expenses. This should be enough to cover most financial emergencies.
Personally, my advice is to look at your bare bones level of monthly expenses. In other words, if you were in a pinch and had to cut your living expenses to a minimum, what would this amount be? You can cut out things like Netflix, Starbucks, and dining out. But, you can’t cut out things like your mortgage, rent, utilities, or car payments.
Once you’ve calculated this bare bones level of living expenses, go ahead and multiply it by six. That way, your emergency fund will keep you going for six months if you need to tap into it to replace a loss of income.
This might seem like overkill. But, if you lose your job, it can take a little time to find another one, especially if the economy is bad. Having a good size emergency fund set aside can help soften the blow and reduce your stress level, at least a little bit.
Saving Tips For Building Your Emergency Fund
Now that you know how much you need to save, you can start working toward your goal. One of the keys to building an emergency fund is to make it a high priority. Personally, I think of this as being near the top of the list in terms of financial priorities, but not necessarily at the very top of the list.
The highest financial priority in my opinion is to pay off high interest debt (i.e. credit card debt). Once this is taken care of, I would shift my attention to building an emergency fund.
Make A Budget
If you really want to save money, it’s important to first understand what your budget looks like. Tracking your expenses is a good place to start. Then, once you have a good sense for what a typical month looks like, make a budget and stick with it.
You can’t expect to build your emergency fund overnight. But, I would try and set a budget that allows you to reach your goal within a year. That way, you’ll be able to cross this financial safety net off your to do list and move on to other financial priorities.
Save Financial Windfalls
One way to turbo charge your savings is to bank any financial windfalls that happen to come your way.
Get a tax refund? Put it in your emergency fund.
Year end bonus at work? Put it in the emergency fund.
New credit card sign up bonus? Well, you get the idea.
Where Should You Keep Your Emergency Fund?
There are different types of savings and investment vehicles that you want to use for different pools of capital. Once you’ve started building your emergency fund, you might wonder just what you should do with the money.
When it comes to your emergency fund, there is a good chance that you won’t need to touch this money for a while. But, you want to be able to access it at a moment’s notice if needed. For that reason, it woundn’t make sense to buy stocks, mutual funds or ETFs with your emergency fund. After all, if the market crashes and you need cash at the same time, it would be a shame to have to take a loss on your investments.
Instead, I would recommend keeping your emergency fund in a high yield savings account. That way, you can earn a decent yield on your cash. But, you can still access it when needed without fear of taking a loss.
Once you’ve built up your emergency fund, you’ll be in a good position to weather whatever financial storms come your way. That means you can begin to turn your attention to other financial objectives. This could be building up your investment portfolio, retirement savings, educational savings or something else. Whatever your personal situation, a good emergency fund will set you on the right path for financial security.