What is an emergency fund?
Sometimes called a rainy day fund , an emergency fund is money that you set aside to serve as your financial safety net for when you need it.
What qualifies as an emergency?
To a certain extent, an emergency varies by the individual, but one way to think of it is as a situation that your normal budget won’t cover and which requires fast action. A major car repair would qualify, especially if you commute. Other examples of rainy day fund expenses include unexpected medical costs, a flight to a funeral or replacing a non-working refrigerator. If you can’t pay these types of bills out of your current funds, you may want to look to your emergency fund.
After you draw on the emergency fund, you’ll want to rebuild it. After all, unexpected events are likely to happen again. A rainy day fund isn’t a one-time proposition.
Now that you know what an emergency fund is and what qualifies as an emergency, follow these steps to start your fund and determine how much you should contribute.
1. Choose a place to keep your emergency fund
An emergency fund is a key first step in developing your financial plan. It amounts to covering three to six months of expenses, usually kept in a basic savings account, for you to use in the event of a job loss or financial emergency.
Your emergency fund should be kept safe and accessible. You don’t want to lock it away in an investment product that’s difficult to tap into or that has a fluctuating value.
2. Make automatic contributions to your fund
The key is consistency. Even a small amount of money adds up over time. Consider setting up a recurring transfer to a dedicated savings account. Having the amount taken out of your paycheck can help remove the temptation to spend the money.
To determine the amount you should set aside each paycheck, some simple math is involved.
Let’s say you’re trying to save $12,000 and you get paid twice per month. If you’re able to stash away $250 per paycheck, it’ll take you two years to reach this goal. If you can save only $100 per paycheck, it’ll take five years. Play around with the numbers until you find a solution that works for your timeline — and your budget.
As tempting as that money may be, part of developing sound financial practices is being disciplined about your spending. Such discipline will help you build your emergency fund and save for other things you want.
3. Know your monthly income and expenses
Building your emergency fund involves setting aside extra money from your paycheck. The amount depends on how much you earn and what your expenses are. It may take a while to reach a suitable level, but it’s a foundation for financial success.
How much should you have in emergency savings ?
Some experts recommend that you set aside enough money to cover six to 12 months of living expenses. While that’s a good goal, it may not be realistic. You might begin by saving enough to cover one month of expenses. Then, save enough to cover three months of living expenses. Don’t know how much to save? Consider the tips below to help calculate your emergency fund amount .
Step 1. Add up monthly living expenses
Start by understanding how much your expenses are in a typical month. Add up all your recurring costs (housing, loan payments, etc.) along with incidentals, such as gas, groceries, and entertainment.
Step 2. Multiply by 3
Multiply the monthly expenses you just determined by three. This will total to three months’ worth of expenses – the minimum amount you should aim to save.
Step 3. Optional: Calculate three months of wages
Calculate three months of wages and set that as your goal. The disadvantage of this method is that if you’re already in debt, it may not give you a high enough goal to work toward.
The payoff of the money savings habit
Many people may learn, after they set up their rainy day fund, that they don’t need it much. That’s because they’ve gotten into the habit of saving.
If you start living on less than you make, even by a small amount, you build a little slack into your budget. This makes it easier to cover surprise expenses. The car repair that once may have sent you to your credit card, and then to your emergency fund, can now be covered out of your monthly budget. That’s a nice benefit to developing good savings habits.
As your life changes, you may need to increase or decrease the size of your emergency fund. Have you bought a car that requires more expensive repairs? Or is it more reliable than the car you’re replacing? Have you started a family, or has your youngest child graduated from college? You’ll need to evaluate your expenses to ensure that your emergency fund is enough to cover them.
Should you pay down the debt before you start saving?
The short answer: it’s a balancing act. One of the best moves you can make as you work your way out of debt is to make choices now that set you up for success in the future. It’s possible that an unexpected expense is what got you into debt in the first place. The key is to balance your savings while paying off debt.
Whatever your financial situation is, you want to have a cushion. Using your rainy day fund can help cover the cost of emergencies without damaging your financial position or causing you to take on debt. Consider using these tips to save money and grow your savings.