We all know that saving money is important. But stashing those savings into an emergency fund can be a game changer for your financial future.
Essentially, an emergency fund is a pile of cash on standby for any unexpected expenses that life throws your way. You might dip into these savings when you face an unexpected car repair or rely on these savings after a job loss.
If you want to build an emergency fund, you are in the right place. Let’s explore how to build an emergency fund.
Why Should You Build an Emergency Fund?
On the surface, building an emergency fund might seem like just another financial chore. But the reality is that an emergency fund might be your single greatest financial tool. An emergency fund can come in handy for a variety of reasons. Here’s a closer look at why building an emergency fund should be a financial priority.
Financial Cushion
The primary purpose of an emergency fund is to provide some financial security. In other words, if something goes wrong in your financial life, you can tap into your emergency fund to smooth over the issue with minimal damage.
For example, let’s say that your car breaks down. Instead of stressing out about how to pay the mechanic, having an emergency fund on hand means you know you already have the funds to cover it.
Regardless of where your financial situation stands, having immediate access to cash to cover an unexpected expense is always a relief.
Lower Financial Stress
A recent Mind Over Money survey, conducted by Capital One and The Decision Lab, found that 77% of Americans feel anxious about their financial situation. With over three out of four Americans facing financial anxiety, it’s a pervasive problem that you or someone you know is likely facing.
One way to lower financial stress is to build out an emergency fund for unexpected expenses. Although you cannot control what expenses life throws your way, you can be reasonably prepared. For example, building an emergency fund means that you don’t have to worry about how you are going to pay for a home repair. Instead, you can pull the necessary money out of your emergency fund.
Lowering your financial stress doesn’t just feel good at the moment. It can have long-term impacts on your financial situation. According to the Mind Over Money survey, Americans feeling financial stress are less likely to save or plan ahead for big expenses. Ultimately, thinking about the bigger picture can lead to feeling more in control of your finances.
Build Financial Flexibility Into Your Life
A paycheck-to-paycheck financial situation is stressful. If one thing goes wrong, it’s possible that you won’t be able to make it to payday without reaching for your credit card. When you have an emergency fund in place, it can breathe some financial flexibility into your life.
For example, you might feel more able to take an unpaid sick day when you have an emergency fund on hand to make up the difference. Or you might have an opportunity to save on a big cost by paying for the bill upfront.
As you navigate life, the financial cushion of an emergency fund gives you more flexibility in the choices you make.
Protect Your Credit Score
Protecting your credit score is one more benefit of having an emergency fund on hand. The reality is that life throws unexpected expenses your way whether or not you have an emergency fund. If you get stuck facing a big expense without an emergency fund, you might resort to credit to cover the cost.
Relying too heavily on credit means you might end up borrowing more than you can afford to pay back. Even if you can afford to repay the lender, the interest charges will add to the expense.
When you have an emergency fund, you don’t have to rely as heavily on credit. With that, you are in less danger of overborrowing, which ultimately protects your credit score.
How to Build an Emergency Fund
It’s clear that an emergency fund is a useful financial tool. If you want to build an emergency fund of your own, here are the steps you can take.
Decide How Much You Want to Save
The first step to building an appropriate emergency fund is to determine how big you want it to be.
As a general rule of thumb, many experts recommend saving at least three to six months’ worth of expenses in your emergency fund. For example, let’s say you spend $2,000 per month. If you followed this rule of thumb, then your emergency fund would be between $6,000 and $12,000.
However, you’ll need to decide for yourself what size emergency fund is best for your lifestyle. Personally, my freelancing career comes with an irregular income. With that, my husband and I have opted to build a larger emergency fund. But those with a more reliable income and in-demand job skills might feel comfortable only keeping a month or two of expenses on hand.
The amount you decide to save also comes down to your comfort level. For example, my low risk tolerance has led to a larger emergency fund. But those with a higher risk tolerance might feel comfortable with a smaller emergency fund.
Break Up Your Savings Goal
After you’ve determined your ideal emergency fund amount, you might decide to break up this major goal into more manageable chunks. For example, saving $20,000 might feel unrealistic. Instead of giving up, consider working on saving $1,000 at a time, or try a different savings challenge.
Or you might decide to build a relatively small emergency fund to tide you over while working on other financial goals. For example, Dave Ramsey recommends sticking with a $1,000 emergency fund while paying off consumer debt. After your debts are repaid, then you have more capacity to build an emergency fund. But you’ll need to decide on the correct order of operations for your financial picture.
Set Up a Timeline
Once you have a target number in mind, you can consider your timeline for this savings goal. Start by considering how quickly you’d like to build an emergency fund in an ideal world. For example, you might want to have one stocked in one year.
But depending on where you are starting from, it might take a considerable amount of time to build a fully stocked emergency fund. With that, it’s important to take a realistic look at your budget. Determine how much you can realistically afford to stash ahead each month with your current budget. If you are committed to your ideal timeline, you might decide to make cuts in other areas of your spending to reach this goal faster.
As with any savings goal, it’s important to create a realistic budget. If a savings goal isn’t realistic, you aren’t as likely to stick with the plan. For example, building an entire emergency fund by the end of the month is likely too big of a challenge for most of us. But stocking an emergency fund over the course of a few years might be more manageable for your budget.
With a timeline in mind, you can determine how much you need to save each month to reach your emergency fund goals.
Here’s an example of an emergency fund timeline:
Calculate your savings goal: Let’s say you spend $2,000 per month and have a savings goal of $12,000.
Choose a timeline: In this example, let’s say that you want to build this emergency fund within one year.
Savings goal: With these details, you would need to save $1,000 per month for one year to build your desired emergency fund within one year.
Run the numbers yourself to map out a path to your emergency fund goals.
Open a High-yield Savings Account
Now that you know how much you want to save, it’s time to decide where you want to stash this nest egg. Although your initial plan might be to simply put these savings in a regular savings account, it’s better to choose a high-yield savings account.
Essentially, a high-yield savings account pays you interest on your savings. Instead of collecting dust in a traditional savings account, your funds can earn a bit of interest in a high-yield savings account.
When selecting a high-yield savings account, it’s smart to shop around. Different banks offer different interest rates. And the right interest rate can make all the difference. For example, you can tap into a 3% APY through Capital One’s high-yield savings account. That’s significantly higher than the national average interest rate for savings accounts, which was 0.23% as of March 1, 2023.
Stash Away a Predetermined Amount Each Month
After you’ve opened a high-yield savings account, it’s time to start actually putting savings into the account.
If you’ve determined how much you want to save each month, start tucking those funds away. As you get started, you’ll likely run into other things you’d rather spend the money on. But if possible, stick to your savings plan until you reach your emergency fund goals.
Consider Automating Your Savings
One of the most difficult parts of saving money is recommitting to the plan every single month. If you have to log into your bank account to transfer savings manually every time, there is a higher chance that you will miss your savings goals along the way. After all, handling this money to-do is a chore that can easily slip your mind.
If you are worried about forgetting to transfer money to savings, consider automating the process. Many banks offer the ability to schedule recurring automatic transfers from your checking account to your savings account. Take advantage of this helpful feature.
Use the Fund for Emergencies
As you build your emergency fund, you might run into unexpected expenses along the way. If you do, don’t be afraid to tap into the funds you have available. Although you might see emergency expenses as a setback, that’s exactly why you have an emergency fund in the first place.
However, do your best to only use your emergency fund for true emergencies. While paying for a car repair or medical bill is an unavoidable emergency, a sale at your favorite store isn’t an actual emergency. Be honest with yourself about your financial choices to avoid spending your emergency fund prematurely.
Frequently Asked Questions
How much money do you need for an emergency fund?
You can build an emergency fund of any size according to your needs. But as a rule of thumb, an emergency fund should hold between three to six months’ worth of expenses.
How fast should I build my emergency fund?
The faster you can build an emergency fund, the better off you will be. However, building an emergency fund will not happen overnight. It’s important to be patient with yourself as you work toward this big goal.
What are three to six months of expenses?
Everyone has different expenses. You can determine your expenses by tracking how much money you spend in a month. For example, if you spend $3,000 per month, then three months’ worth of expenses would be $9,000.
How do you do the 50/20/30 budget rule?
The 50/20/30 budgeting rule involves breaking down your spending into three major categories. First, this budgeting framework recommends spending up to 50% of your income on unavoidable costs, like food, housing, and transportation. Next, you spend 20% on savings and debt repayment. Finally, you spend the remaining 30% on discretionary purchases, like travel, dining out, and lifestyle upgrades.
The Bottom Line
A robust emergency fund can be there to support you financially during difficult times. Whether you run into an unexpected medical bill or lose your job, you can fall back on this stash of cash to make it through.
Everyone’s emergency fund will look a little bit different. But even a small emergency fund can help you avoid relying too heavily on credit when facing an unexpected expense.