Emergency Fund: What it is, Why it Matters, and How to Build One
Has the global COVID-19 pandemic prompted you to rethink your money moves?
Bravo if you put establishing an emergency fund at the top of your list. An emergency fund is one of your most powerful tools to weather life’s crises.
But what is it and how can it impact you? Let’s take a closer look.
What’s an emergency fund?
Simply put, an emergency fund is your personal financial safety net. It’s highly liquid, such as a cash or money market account kept separately from your regular checking and savings account, and set up to cover large, unexpected expenses.
What kind of expenses? You may be thinking “gas line repair,” “new roof” and “unforeseen medical expenses.” Six months ago, these may have been at the top of the list.
But the ongoing pandemic has shifted our thinking. Now many people want to earmark that emergency fund as their primary source of support for themselves and their families in case of unemployment. Since March, more than 40 million Americans of all income brackets and occupations have lost their jobs because of COVID-19 and the subsequent economic fallout. Although some hiring has resumed, uncertainty prevails.
You want to be prepared.
Depending on your family situation (single, married, a working spouse, minor dependents), aim for emergency savings to cover up to nine months of expenses you may have to pay due to unemployment.
That buffer will allow you to continue paying your monthly rent or mortgage, food and medications, private school tuition, utilities, car loan, insurance, plus property, and real estate taxes.
For example, Susan and David have expenses totaling $9,000 per month. They both work full-time, but if Dave were to lose his job, then Susan's salary would only cover $3,000 of their monthly expenses. This leaves $6,000 per month in expenses that they won't be able to cover. Susan and David should target $42,000 to $63,000 for their emergency fund. This equates to six to nine months of expenses.
Emergency funds aren’t just for working families, even retirees still need a healthy emergency fund. We typically encourage our retired clients to have between one to two years of expenses saved up in an emergency fund or as part of their overall retirement portfolio. It’s good to have cash on hand in case of any dips in your nest egg.
Create a separate rainy day fund
In addition to your emergency fund, you want a rainy day fund. This is a smaller savings account, also kept separate from your regular checking account, for life’s less traumatic hiccups: new tires or a malfunctioning water heater. Try to build up $2,500 to $5,000 in this account or the equivalent of one month’s pay.
Why do you need both?
An emergency fund preserves your financial security and boosts your peace of mind. You will withstand life’s major blows much better if your finances are in good shape.
Consider the benefits of an emergency fund:
Intact retirement accounts. You won’t have to dip into your IRA, 401(k) or Profit Sharing Plan. Those withdrawals, while permissible under IRS rules for certain expenses, might cost you dearly in terms of lost investment earnings, income taxes and possibly, penalties. That could mean delaying your retirement or jeopardizing your lifestyle in retirement. No need to face those consequences if you have a well-endowed emergency fund.
Control over your investments. You want to decide when to sell your securities so you can minimize losses when stocks are down and excessive capital gains taxes when stocks are up. A financial crunch could necessitate unfavorable selling choices, but an emergency fund lets you stay in charge.
No new debt. The last thing you need during a major crisis is additional debt from credit card spending or personal bank loans. Credit card debt, in particular, can wreak havoc on your finances, especially if you, like almost half of all Americans using credit cards, carry balances from month to month. Credit card interest rates are among the highest on any consumer debt, exceeding 17% on average, and late fees carry an additional punch. More debt also harms your credit score, making it even more expensive to borrow. It’s a scenario you can avoid if you have money squirreled away in an emergency fund.
Maintain personal relationships. You probably know this proverb: “Before borrowing money from a friend, decide which you need more: the friend or the money.” Asking friends or family members for loans typically strains the relationship even if you manage to pay back all that you owe.
A good night’s sleep. You’ll sleep better and have an optimistic outlook even in darker times knowing your emergency fund is carrying you through this time of financial hardship.
How to build (or replenish) your emergency fund
Saving up thousands of dollars for emergencies is daunting, no question about it.
But the good news is that you can start small and set your own pace. With time, as your savings and your sense of financial well-being grow, you’ll discover that you actually enjoy putting money aside.
Here are some suggestions to help you get started:
Open two new bank accounts, one designated as your emergency, the other as your rainy day fund. These should be no-cost, highly liquid cash, or money market accounts.
If you are employed, ask your human resources department to direct payroll deductions of your choosing into those accounts each payday. You can start small like $50, which could add up to $1,300 over one year. Alternatively, instruct your financial institution to automate those money transfers. Save regularly and consistently every week, every month!
Increase the regular savings as you are able to.
Channel all or parts of financial windfalls, such as an IRS refund, a raise, or bonus into those accounts.
After you have paid off any outstanding loans, continue the monthly payments, but make them to yourself by transferring the money into your emergency/rainy day funds.
For additional cash boosts, consider taking on a part-time job for a few months, selling some rarely used household items and kitchen gadgets, or canceling select media subscriptions and club memberships. Add the extra earnings and savings to your cash reserves.
Once your emergency fund has reached the desired balance, channel all future deposits into your rainy day fund.
Pro Tip: Want to save even more?
If you own a house or a condo, you know there will be repairs at some point.
Try this savings strategy to be prepared: Calculate 1 to 1.5 percent of the value of your house and divide that amount by 12. Set this sum aside each month to build up a house repair fund. For example: If your house is worth $200,000, divide 1 percent of its value, 2,000, by 12: $167. Save this amount each month. Over time, you’ll grow a comfortable cushion to draw from when the air conditioner conks out.
Consider a similar strategy to be prepared for car repairs, your family vacation, and holiday presents. Christmas is December 25 each year, no surprise there. Nor should be your expenses. Establish a budget in advance, divide by 12, and save those amounts each month.
Emergencies should always be part of the plan
Life can throw some unexpected curve balls your way. You need to be prepared for a tough financial storm, whether it be a leaking roof, plumbing issue, unexpected hospital bills, or losing employment.
Planning when times are good will help you stay afloat when times are bad. Our team is always here to help you craft a plan that will support you throughout all of life’s journeys. If you would like to talk to us about revamping your savings plan, give us a call today.
We can help establish your personal savings plan for life’s bigger and smaller emergencies.
Mark Fonville, CFP®
Mark has over 18 years of experience helping individuals and families invest and plan for retirement. He is a CERTIFIED FINANCIAL PLANNER™ and President of Covenant Wealth Advisors.