Unemployment. A car accident. A medical emergency.
You never know when a financial emergency will strike!
The last thing you want to worry about in a crisis is how you will get by financially. Your budget needs to be prepared for these unexpected events.
This is why everyone needs an emergency fund.
People tend to have their own definitions of an emergency fund, what it means to them, and how large it should be. And that is fine. You need to do what works for your situation.
We’ll cover these topics and much more in this article.
We want you to be prepared to handle any financial emergency that may arise, and your emergency fund is the best place to start.
(HINT: We’ll also give you some ideas for other ways you can protect yourself and your financial situation.)
Table of Contents
Why You Need an Emergency Fund
Financial emergencies come in all shapes and sizes.
Insurance shifts risk and can offer the policyholder financial relief when needed.
But insurance may not cover the entirety of every financial emergency. That is why you need an emergency fund; to help cover unexpected financial needs.
For example, suppose you are living paycheck to paycheck and don’t have any cash reserves. In that case, even a minor financial emergency can set you back months – causing you to get into debt and increase the amount you owe creditors.
An emergency fund can help you avoid that situation.
By planning for the unplanned, you relieve stress, reduce risk, and increase your financial flexibility.
How Much Should be in Your Emergency Fund?
This is an area where each expert has an opinion, and the answers vary.
Some people recommend at least 3-6 months of living expenses, 6 months to a year, and a few thousand dollars. In my opinion, this is a very personal decision and should be based on your circumstances.
Where most experts agree is that you should base your emergency fund on your expenses, not your income.
So if you measure your emergency fund in months, it makes more sense to measure in months of expenses, not your income.
Most importantly, you are starting a habit of saving money.
As you cut other expenses from your budget, and as you look for more sources of income, you can begin increasing the amount of money you put into your rainy day fund. But first, you must be in the habit of “paying yourself first.”
How large should your emergency fund be?
If you have no debt and minimal living expenses, you can probably get away with a smaller emergency fund than someone who carries a large amount of debt and has high monthly living expenses. Another factor to consider is your income and employment status. Someone who works for the government or is in a stable industry may keep less than someone who is self-employed or works in a volatile industry that often experiences layoffs or seasonal work.
As a rule of thumb, I would start with a $1,000 emergency fund (at the minimum). Then work up to a level that gives you the financial flexibility you seek.
How large is my emergency fund?
I am self-employed, so I feel better having a larger emergency fund to ensure I have cash on hand if anything pops up.
My cash flow can also be irregular. So having cash on hand reduces risk. In my case, I started with the $1,000 emergency fund, then built it up to the $10,000 mark.
Now I keep at least 6 months of living expenses in cash – just in case.
Having this amount of cash on hand helps me rest easy, knowing that I am prepared for just about any issue that may arise.
What does Dave Ramsey recommend?
Dave Ramsey’s Baby Steps are a financial plan to get out of debt and become financially free.
Dave Ramsey recommends:
- starting with a $1,000 emergency fund
- paying off all debts except for your mortgage
- then saving from 3-6 months of expenses before moving to the next step, investing 15% of your household income
Where to Open an Emergency Fund
You want the money to be liquid so you can access it at a moment’s notice, and you also want to ensure your money retains its value.
Your emergency fund isn’t designed to grow wealth, it is designed to preserve your financial flexibility and help prevent you from going into debt.
So you don’t want to keep your emergency fund in stocks or mutual funds, which can vary substantially according to the markets and may take several days to cash out and transfer the funds to your bank account.
Keep Emergency Funds Separate
It’s also a good idea to separate emergency funds from your primary checking or savings account.
You want the money to be accessible if you need it, but not so accessible that it is mixed with your regular funds or you are tempted to spend it.
You can usually transfer money between banks within 1-3 days. So keeping your emergency fund in a separate savings account is a great way to avoid the temptation to spend it on non-critical expenses.
The best places to keep your emergency fund are accounts that offer quick access and a stable rate of return.
Be sure to find a bank that offers high interest rates because the idea is to let the money sit there until needed. You can check with your local brick-and-mortar bank or credit union or use an online savings account.
Look for High Yield Accounts
You won’t ever get really good rates on cash products. That is no excuse not to get what you can, though.
You can also look for incentives, such as cash bonuses for signing up for certain accounts, and other perks.
This will help you increase the value of your account without too much trouble.
Consider a CD Ladder for Your Emergency Fund: A CD Ladder allows you to stagger your CDs so you can earn more money than a standard savings account and still have access to the money regularly.
5 Smart Accounts for Your Emergency Fund
While growing your emergency savings is crucial to maintain optimal financial health, you should also think long and hard about where to store your funds.
A basic savings account may seem like your best bet, but the reality is that most regular savings accounts pay very little in interest.
Not only that, but you may also encounter some issues if you comingle your emergency fund with your regular savings. It may be easy to spend your emergency fund on non-emergencies if you keep it in your regular account, for example.
Ideally, you’ll want to store your emergency fund in a separate account designated for emergencies and earn a higher-than-average return each year. Here are a few options to consider:
1. High-Yield Savings Account
A high-yield savings account can be a smart place to keep your emergency fund provided you conduct due diligence to find an account with a decent APY. These accounts are easy to research and open on your own, and I’ve compiled a list of the best high-yield savings accounts to get you started.
Plus, many high-yield savings accounts offer online account management services so you can keep track of your balance, make deposits and withdrawals, and oversee your account details from the comfort of your home.
Before opening a high-yield savings account, make sure you’re aware of deposit requirements or rules that dictate how much interest you’ll earn.
2. Money Market Account
A money market account is a type of account that typically pays more interest than a traditional savings account. Many money market accounts require a higher minimum deposit to get started than savings accounts, and they tend to come with debit cards and the ability to write checks.
One benefit of using a money market account for your emergency savings is that, like savings accounts, your money is easy to access.
You can open a money market account online and from the comfort of your own home, but you can also open one at your local bank or credit union.
3. Certificate of Deposit (CD)
A Certificate of Deposit (CD) is a financial instrument you set up with a bank for a specific time. CDs pay a set amount of interest for the length of the term, and they typically pay much higher rates than savings or money market accounts.
It’s common to see CDs that last from three to five years with nearly any type of minimum deposit requirement. The problem with CDs is that, unlike savings and money market accounts, your funds are not as easily accessible.
You’ll have to pay the penalty to withdraw your funds before your CD matures, and the penalty is typically equal to several months of accrued interest.
For this reason, it may not be ideal to put all your emergency funds into a single CD. However, you could opt to put part of a larger emergency fund into a CD and the rest in a savings account.
4. Roth IRA
While a Roth IRA may seem like a strange place for your emergency fund, there are plenty of reasons you may want to consider this option. It’s possible to contribute up to $6,000 to a Roth IRA in 2019 and you can invest your funds in mutual funds, ETFs, stocks, bonds, and other investment options.
However, unlike other types of retirement accounts, the Roth IRA lets you withdraw your deposits (not your earnings) at any time without a penalty.
This is the reason many people use a Roth IRA for long-term savings goals, including retirement. You can withdraw the funds you’ve contributed without penalty, but you can also let your funds continue growing if you don’t need them.
The best part is, that a Roth IRA is made with pre-tax dollars and allowed to grow tax-free for life. When you finally take distributions in retirement, you can access your funds tax-free.
On top of the fact that a Roth IRA leaves your deposits easy to access, this type of account also offers the potential for a high rate of return. Of course, the opposite is also true; if your investments lose value, your emergency fund will also be worthless.
Keep in mind, however, that income limits dictate how much you can earn and still invest in a Roth IRA. If you earn too much, this type of account isn’t an option for you through traditional means.
If you’d like to invest in your Roth IRA without the hassle of managing it or having to deal with an investor, I recommend Betterment. Betterment is an affordable robo-advisor with low management fees and a $0 account minimum.
Its algorithm will keep your investments on track to meet your goals, automatically rebalancing your account with custom-made Roth IRA options.
5. Taxable Investment Account
Finally, don’t forget that it’s possible to keep your emergency fund in a taxable investment account. This option comes with the same benefits and drawbacks as a Roth IRA — you have the potential to earn an extremely high rate of return, but you could lose money from your emergency fund if your investments perform poorly.
A taxable investment account can be opened with any online brokerage firms, and many charge few or even no fees for trades. Online brokerage accounts are also available to anyone with no limits on how much you can earn.
However, taxable accounts do not come with the same tax benefits as tax-advantaged retirement accounts like the Roth IRA.
But with a taxable investment account, you have access to loads of funds to invest in, you aren’t capped by income or max contributions, you can withdraw without penalty at any time, or you can keep your funds invested without any required distributions.
That type of flexibility could be beneficial for an emergency fund.
How to Quickly Fill Your Emergency Fund
Hopefully, you understand your cash flow well (a working budget is helpful here).
This will make it easier to find areas where you can free up cash to divert to your emergency fund. Consider treating your emergency fund like a bill and sending a predetermined amount to your emergency fund each pay cycle or month.
A good way to do this is to automate it through automatic payroll deduction.
You can also find areas to cut back from your regular budget or send any overages to your emergency fund. For example, if you budget $500 for groceries and only spend $400, you can save the $100 toward your rainy day fund instead of spending it elsewhere.
Other ideas include funding your account with bonuses, tax returns, income from a side job, etc.
A lot has been written about the advantages of automating your money, for a good reason.
You can automate your savings so that your money goes into your rainy day fund. You can have the money taken from your paycheck and deposited directly into your savings account, or you can set up recurring transfers that move money from your checking account into your savings account once a month.
In either case, the temptation to use the money for something else is removed; you never really have access to it in your checking account.
And, your savings account grows at a steady rate.
You don’t have to fund it all at once. Many people can’t afford to earmark several thousand dollars for a financial emergency immediately.
That’s OK. But it’s a good idea to get started and to make it automatic, if possible.
Start by transferring the amount you can afford to a separate savings account. You can do any amount you want, just keep in mind the faster you build your emergency fund, the faster you will have that insurance against unexpected expenses.
You could start by transferring $50 per paycheck, or $100 per month, or any number that works for your budget.
Advanced Emergency Fund Strategies
Some people recommend having only one general emergency fund to cover any large, unexpected expense.
But some people believe in using sub-accounts to manage your emergency funds. This could be separate accounts for an unexpected expense for your house, car, etc.
Do You Have One General Emergency Fund?
I hope you have a general emergency fund.
Maybe you’ve earned a gold star and have funded that account with 6 months of living expenses.
But have you defined what the emergency fund is for?
In my eyes when you say your emergency fund has 6 months’ worth of living expenses in it then that isn’t just an emergency fund.
That’s an unemployment fund.
You’ve tied the total in the account to a purpose — living off of it without any income. That sure sounds like unemployment to me.
Now, just apply that idea to other areas of your life.
Many Funds for Many Purposes
Two weeks ago my wife ran over a screw in the road and was rewarded with a flat tire. Thankfully we had set aside money specifically for car problems. You might say we had a car maintenance emergency fund.
If our clothes washer died today we have a small pile of money sitting aside just for home maintenance. We tap that money for any home-related emergencies we have.
Just take this idea and expand it to fit your situation. You may need an unemployment fund, car and home maintenance funds, and a “the kids are bound to get sick” fund.
Use Sub Accounts to Track Your Savings
How can you track all of your emergency funds targeting specific types of emergencies?
- Track everything within one large savings account and break out the individual funds on paper or a spreadsheet, or
- have separate bank accounts for each fund (this can also be accomplished by using sub-accounts if your bank supports this feature).
Option 1 can get pretty complicated, and you have to be good at keeping things separate.
At the end of the day, if all the money is in one big account, you have to mentally say, “Okay, of that money, only this much is for this emergency.” It can be easy to dip too far and too often into the account.
Option 2 is superior for many people. By keeping the money in separate accounts, you drastically reduce your chances that you will dip into one of the other accounts to pay for this account’s emergency.
For example, if you have $500 in the car maintenance fund and $500 in the home maintenance fund and a $300 car emergency, that money needs to come from the car money.
Because the next thing you know, you’ll have a $500 home repair!
Some banks have a feature that allows you to create sub-accounts within your main account, so you can earmark funds for a specific purpose while keeping all the money part of one larger account.
Capital One 360 makes this incredibly simple to do. You can open up a bunch of accounts within your one main login.
All you do is click “Open an Account” and give it a name like “Car Maintenance,” “Home Repair,” or something similar.
Ally Bank is another bank that has similar features.
These sub-accounts can also be handy in saving for goals, too. For example, saving for a vacation or a Christmas fund. Again you are trying to keep the goal money away from your other costs and away from your ability to easily spend it.
Other Ways You May Be Able to Cover Emergency Expenses (Not Always Recommended)
Sometimes emergencies pop up that are larger than the size of our emergency fund. In those times, you may need to look into alternatives, such as the following ideas:
Selling Unneeded Items
Sometimes you may be able to raise some quick cash by selling items you have but no longer need.
Selling things on Facebook, Craigslist, eBay, and other platforms can be a quick way to raise some cash. Go for high-value items that may be easy to move – think about electronics you no longer need, old instruments, furniture, or anything else that you can convert to quick cash.
What About Using Credit Cards or Other Credit for Emergencies?
The point of an emergency fund is to avoid using credit for unexpected expenses.
So while using a credit card or another loan is certainly an option, it should be near the end of the list. Using credit for an emergency can worsen the problem, putting you deeper into debt. The clock is always running on the interest, and it may take you months or even years to repay the loan.
Credit cards and other loans can be convenient when you take them, but it is rarely convenient to repay them.
I recommend not using a HELOC for financial emergencies unless it is unavoidable. Your HELOC is tied to your home equity, meaning you are using your home to secure the loan.
If you don’t repay that amount, you could lose your home.
What About Tapping into Retirement Funds?
This should be considered a last-case scenario because it can set your retirement planning back several years.
You can repay a 401k loan, but it will still hurt your retirement fund. Suppose you withdraw from a retirement account instead of taking a loan. In that case, you will be subjected to immediate taxes and possibly early withdrawal penalties if you are under the minimum withdrawal age.
Last week I told my readers that my wife and I prepare for unexpected expenses by creating mini-emergency funds targeted at those potential expenses.
Unplanned expenses are a fact of life. As with anything, you can choose to close your eyes and cross your fingers, hoping they won’t happen to you, or you can prepare for them.
We choose to prepare for the things we identify as potential upcoming expenses.
I’m talking about car maintenance (flat tires, parts fail) and home maintenance (air conditioner or heater goes out, water heater quits, dishwasher dies).
These things are inevitable over time.
Why not prepare today?
Beyond the Emergency Fund: Other Ways You Can Protect Yourself Financially
Every so often it’s a good idea to review your budget to see how your cash flow is doing.
Being familiar with your budget will help you identify areas where you can cut back if you come upon a situation where you may need to make long-term lifestyle changes or if you need to make changes to your spending habits.
These can be both planned and unplanned situations – not just emergencies.
Prepare for Possible Changes to Your Financial Situation
Here are some scenarios to consider:
- Changing from a two-income household to a one-income household (stay-at-home spouse, retirement, etc.).
- Death of a loved one (estate planning, wills, adequate life insurance).
- Other emergencies (illness, disability, natural disasters, etc.)
None of these situations are pleasant to think about. But it’s important to do so. A little planning on the front end can save you and your family from a major financial disaster.
How You Can Mitigate the Issues
Thankfully, there are some steps you can take to mitigate the above situations with the proper insurance policies, estate planning documents, and other planning.
Look for budget cuts. When faced with a longer-term situation, you will most likely need to make big changes in your spending patterns.
That will include cutting back in some areas. Going through your budget and noting areas where you can cut expenses will make that process easier if an emergency strikes.
Can you increase your income? It’s also a good idea to look for ways to increase income, especially in the event of a job loss.
An Emergency Fund is One of the Best Financial Decisions You Can Make
An emergency fund is one of the most important financial steps you can take after becoming current on your living expenses and graduating from living paycheck to paycheck. And with a little planning and luck, it can help you manage unexpected expenses and avoid debt.
If your goal is building wealth while avoiding most of life’s financial pitfalls, an emergency fund can help on both fronts.
Not only can an emergency fund serve as another form of savings you can use later in life, but having money set aside for emergencies is crucial if you face a surprise bill you can’t afford to pay, you lose your job, or you experience a loss in income.
How much should you keep in your emergency fund?
While there’s some debate over how much you need, most experts agree that something is always better than nothing.
It’s probably feasible to start with $1,000 and work your way up from there. Over time, however, you should strive to keep between three and six months of expenses earmarked for emergencies that might otherwise derail your financial plans.
This may seem like a lot of cash lying around, but you’ll be glad you have it if you have to deal with a financial emergency.
With a fully-funded emergency fund, you can keep up with your bills and avoid debt and default while getting back on track.
The Bottom Line
If you’re building up your emergency savings, you’re on your way to shoring up your finances for good. That’s great, but you also need to decide where to keep your money so it is earning interest and safely out of sight.
Any accounts on this list could work well for your needs, but compare them based on your risk appetite and how accessible you want your money to be. Your emergency fund is a crucial component of your financial health, but the best place to keep it is different for everyone.