“What is an emergency fund? How much money should you even keep in an emergency fund? Or is it better to think about how many months you'd need an emergency fund for? Where to even put an emergency fund? Is it better to have cash at home?” are just a few of the questions I get regularly. All of which we will tackle today in this quick and simple guide for coming up with a good savings plan to stack your emergency fund and maximize savings!
This post is sponsored by Lexington Law, a trusted leader in credit repair. An emergency fund is here to help you when the unexpected comes up so you don't have to put yourself at risk of destroying your credit. With that said, even when you have a stacked emergency fund, things can still happen to your credit profile. In fact, solutions such as student loans, unplanned medical expenses, recent military leave or divorce can make it more likely to have unsubstantiated negative effects to your credit. If you've experienced poor credit due to inaccurate, unsubstantiated, or unfair items on your credit profile, get your FREE credit report consultation today by click here! After all, the entire point of an emergency fund is to build a strong financial foundation, and that includes protecting and repairing your credit score.
A Complete Guide To Your Emergency Fund [What, Why, How Much, + Where To Park It?]
What is an emergency fund and why do you need one?
An emergency fund is exactly what it sounds like: money earmarked for an emergency.
The keyword being an EMERGENCY. Things like your roof unexpectedly leaking, a flat tire, or even suddenly losing your job are all examples of emergencies that you could happily dip into your emergency fund for to increase peace of mind, stay out of debt, and stay on track with your long term financial goals.
Why you need an emergency fund (and who needs to prioritize it even more):
Emergency funds are essential for everyone, but are an even higher priority for those carrying debt in my opinion.
Stick with me here: have you ever set a New Year's Resolution to lose weight? You start going to the gym, eating better, and feel great. Then it's Karen's birthday and the office brought in cupcakes and are going out to dinner to celebrate. Not only do you indulge in the cupcake, but you skip your regular gym class… the next day, you're tired from the sugar hangover and decide to skip the gym again… before you know it, you're right back where you started. Yeah that same slippery slope can happen when trying to pay off debt.
Only instead of Karen's cupcakes, it's a flat tire causing you to skip a debt payment to cover, then the next month it's an unexpected trip to urgent care, causing you to skip a payment again. Do you get it? An emergency fund becomes the buffer to stay on track so you don't just throw in the towel when something inevitably comes up. A lack of savings can increase your debt according to this article from Lexington Law.
Emergency fund vs. saving funds
Emergency funds are not the same as savings funds. Your savings are for your financial goals. Too often I see people dipping into their emergency fund for something that should've required a sinking fund.
A sinking fund is for expenses that happen infrequently, but you can plan for them. For instance, you know you'll need to replace your roof after a certain amount of years, so you start preparing for it with a sinking fund. You can learn more about sinking funds here.
How much money should you have in an emergency fund? Or is it better to base your emergency fund off of how many months?
They are kind of one in the same since you need enough money to last you a certain amount of time. You don't need a fancy emergency fund calculator to come up with a number either. Simply look at your annual spending for last year and make that your target number if you're aiming to have 12 months worth of expenses in your emergency fund. If you are looking to have 6 months of expenses in your emergency fund, look at your spending from the last 3 months, come up with an average number, then multiply that by 6 to determine how much money you should have in your emergency fund.
Okay so how many months should we be aiming for then?
For stable employment you'll want 3-6 months worth of expenses in an emergency fund. When I say stable, I mean truly stable; like doctors, nurses, delivery people – basically any job we are still seeing a high demand for during the spread of the virus, is probably in this camp. I look at this camp as anyone who provides a service that is essential to living.
For mostly stable employment you'll want to keep about 6-9 months of expenses in an emergency fund. This is for people who are traditionally employed, but maybe their jobs have a higher likelihood of being outsourced, scaled back on, etc. as we are seeing in the current 2020 landscape.
If you don't know which camp you're in, think about the 2008 recession and how your position fared.
For high risk, seasonal, or unstable employment, you'll want to keep 9-15 months of expenses in an emergency fund. This goes for serving tables, self employed, and the like.
Personal example: When I first started dating my husband, he worked on his first startup and I waitressed. I briefly got a 9-5, then ventured into self employment. In that time, my husband sold his company, started working for another company, has since been let go and now is working on his second start up making no money for almost two years now. Our incomes have always been highly variable – even when we have “stable” 9-5's they don't last long so to be safe we keep 12 months of expenses in an emergency fund.
Now, where to put your emergency fund?
Your emergency fund should be separate from your savings account. You want your emergency fund to remain liquid – meaning you have access to it at any time.
In other words, do not put your emergency fund into the stock market where you could be experiencing a loss when you need to pull the money out. You also do not want to put it into a bond, certificate deposit (CD), or any other type of account that locks the money away for a fixed period of time.
Some people like to have emergency cash at home; that's totally okay and up to you.
Personally, when deciding where to park our emergency fund, we opted for a high yield savings account with a digital bank. Will you get rich off the interest in a high yield savings account? Absolutely not. But if you have a year's worth of living expenses in an account, it's better to make roughly 1% on it than .001% as a simple way to maximize savings.
How to come up with the best savings strategy to reach your emergency fund goal:
Once you've calculated how much money you'll want in an emergency fund you may experience a little sticker shock. Do not stress out. The money does not need to be there overnight. Instead, focus on a good savings plan to get started.
Ways to quickly maximize savings:
- Divert a portion of your paycheck into the account where you parked your emergency fund
- Sell your old stuff
- Start a side hustle or freelancing
For more ways to save money, check out my Money Saving Series sponsored by Lexington Law! There is a post with specific ideas for saving money at every one of life's milestones or common happenings (i.e. saving money for a baby or a house, or more everyday things like saving money on grocery shopping or specific holidays! Read them all here).
$1,000 emergency fund challenge
This is my favorite place to start because you can snowball it pretty quickly and make it a game. Enlist a partner and see who can do it faster. Skip your coffees, meals out, and even try cancelling cable or a TV subscription service.
Once you get the ball rolling and reach your first $1,000 you'll start to feel more excited… but again, gamifying it really helps in my opinion.
My suggestion with the $1,000 emergency fund challenge is to do it in a month. I know that may be hard for some people in the current economical times of 2020. Personally, I went through a quick “stress buying” phase. But use this time at home to organize your pantry and closets and see just how much you already have so you don't feel as inclined to stockpile unnecessary items. For instance, you don't need new clothes when you're just going to your living room everyday. You're less tempted by browsing trips at your favorite store or nights out on the town.
Next come up with a 6 month saving plan or an annual saving plan
With your $1,000 saved, hopefully you realized just how possible it is to find extra money in your budget.
From here, you'll want to come up with a savings plan that makes sense for you based on your income, financial goals, and lifestyle. A good rule of thumb is always the 50/20/30 guideline!
Some emergency fund planning examples:
If you have no debts (excluding mortgage or student loan)…
Then just get to work saving money. If your job isn't the most secure, I'd personally only focus on purchasing true necessities and get as much money into my emergency fund as quickly as possible. Also consider diverting any money going towards retirement, into your emergency fund right now.
[RELATED] 19 Tips For Affordable Living On The Fly
If you have debts…
Dave Ramsey recommends the $1,000 as a starter emergency fund. However, I would stress that you consider your starter emergency fund that's a bit larger.
If your goal is 12 months of expenses in an emergency fund, I probably wouldn't wait to tackle your debts until you've reached that number. Instead, I'd focus on 3-6 months in an emergency fund (during less financially challenging times, some people would recommend just having your out of pocket maximum as your target emergency fund number in this scenario, but I wouldn't suggest that right now with the current economy). With all of that said, it's entirely up to you.
While you are putting money into your emergency fund, continuing to pay the minimum balance on your debts so they don't go to collections, and using the excess money to pay yourself first into an emergency fund (remember the gym and Karen's cupcakes example from earlier?).
Once your emergency fund has about 6 months (or whatever number you chose) of expenses in it, start to follow one of these debt repayment strategies. If you need to dip into your emergency fund for any reason, go back to re-stacking your emergency fund as your top priority, and then focusing back on your debts.
Maximizing your emergency fund is possible and worthwhile.
A recent study found that personal finance is about emotions, not math. Keeping an emotional connection to your goals can help. Moreover, having an emergency fund can allow you to approach life from a point of rationale instead of fear. This is a huge win because when we feel more secure, we tend to remove more of the emotions that lead to overspending in my opinion.
I think one of the best things you can do in your financial journey is to lay a strong foundation. Having an emergency fund is a great first step. Repairing your credit is another fantastic step. My friends at Lexington Law are here to help in your credit repair journey too. The current economic and employment landscape means a lot more people are going to be relying on credit for a period of time. If your credit score isn't where you want it to be already, then definitely get your free credit report consultation here. Bad credit can cost you more money in higher interests rates and more. So get that squared away as early as possible so you are on the best footing if you need to start lending again.