An emergency fund is money that you have set aside to cover any financial emergencies or unexpected expenses that may come up. Those can include anything that you haven't planned for, such as unexpected car repairs, medical bills, unemployment or other income loss, property damage, or family emergencies.
It's also wise to prepare for unexpected events with a solid plan in addition to your emergency fund. The Federal Emergency Management Agency (FEMA) offers an "Emergency Financial First Aid Kit" to help you do that.
Reasons for Having an Emergency Fund
Although it may seem like a sacrifice, setting aside money in an emergency fund can provide you with true peace of mind and help you move more gracefully through otherwise stressful situations. It allows you to focus on taking care of the problem at hand without the additional worry about finances during a crisis. The sooner you start on your emergency fund, the sooner you can take advantage of these benefits.
Your emergency fund is also a way to protect your savings. For example, if you're saving for a home, and you have a medical emergency, you will not need to dip into your down payment savings to cover the costs. Instead, you'll use your emergency fund for that. This can help you to continue to move forward with your financial goals even when you face the unexpected.
It is important to establish an emergency fund as soon as possible. Having one can give you peace of mind through a crisis and make it easier to make sound financial decisions.
Starting an Emergency Fund
Before you start an emergency fund, it's a good idea to set a savings goal. The ideal goal amount for your emergency fund will depend on a number of factors, including your income, costs and bills, lifestyle, and number of dependents. If you work in a field where layoffs are common then it's wise to save more rather than less.
A common recommendation is to build your emergency fund to cover at least three to six months of expenses. However, if that seems daunting, then you can start with a smaller, more attainable goal.
You may want to set up a skeletal budget, which lists the items you'd need to cut out immediately if you were to lose your job.
When you're ready to start, take the time to select the right account to hold your emergency fund. You should look for an interest-earning account that lets you access your money quickly if needed. This would include a money market account or a high-interest savings account.
Generally, you want to avoid putting your emergency fund in a Certificate of Deposit (CD) or Individual Retirement Account (IRA), both of which have penalties for early withdrawals.
You can contribute to your emergency fund and work to pay off debt at the same time. You don't have to pay off all of your debt before starting a small fund.
Building an Emergency Fund
Once you set your initial savings goal and set up an account, it's time to build up your emergency fund. There are different strategies you can use to start doing it.
The Consumer Financial Protection Bureau offers a savings planning tool that will help you calculate how long it will take you to reach your goal based on what you can contribute and how often. This is a great place to begin.
To make sure you're consistently contributing to your emergency fund, you can work with your financial institution to set up automatic transfers from your checking account to your savings. You can also commit to contributing to your emergency fund when you receive sums of money outside of your core income, such as gig jobs, income from hobbies and interests, gifts, bonuses, and tax returns.
You may also want to consider using a CD ladder to grow your initial fund once you've built it. To do this, you'd open CDs with different maturity rates that correlate with your goals. Since CDs generally have a higher rate of return than savings accounts, then this strategy could help you build your emergency fund more quickly. However, you'd need to make sure you're okay with having portions of your funds tied up for certain periods of time.
Recently, more investment companies are setting goal-based investment strategies for their clients, including emergency funds. Betterment, Fidelity, Aghaz Investments, and Ellevest are all brands championing goals and have set algorithms designed for emergency funds, among other goals.
If you're interested in using a CD ladder, then it's wise to consult a finance professional before doing so. It's a somewhat advanced strategy that takes careful planning.