Emergencies are unpredictable, by nature, and none of us want to get caught off guard by a huge, unexpected expense.
We have all heard how important it is to have a rainy day fund, but how much should you save, and how do you start saving?
Here we will look at how much money you should save for emergencies and give you some tips on how you can build this into your budget.
What is an emergency fund?
An emergency fund is a separate bank account or savings account that will help offset any unexpected situations that pop up. Such emergencies might include buying a new car if your car suddenly stops working, fixing a leaking roof, or paying for unexpected medical expenses. An emergency fund might also be kept in case a person loses their job. What constitutes an emergency will vary greatly from person to person, so an emergency fund will be used differently by different people.
But the goal of an emergency fund is always the same: it can help bail you out of a tight financial spot.
How much should you budget for emergencies?
Just as what constitutes an emergency will differ from person to person, so too will how much you should save. Emergency funds are often discussed as “how many months of expenses'' you should save. While the general rule of thumb is to save six months’ worth of expenses, this depends a good deal on your lifestyle and financial situation. Let’s look at some different scenarios:
When you should save three to four months’ worth of expenses:
If you are in a relatively stable position in your life and don’t have a lot of people financially dependent on you, saving three to four months’ worth of expenses will provide a good emergency fund. Consider saving this much if the following applies to you:
- You’re relatively young and healthy.
- You have a stable job, and if you lose your job you could easily find a new one.
- You do not have dependents (children or pets).
- You have a partner who is financially stable.
- You have little debt.
If this sounds like you, aim to save for three to four months of expenses.
When you should save six months’ worth of expenses:
If you have a lot of expenses every month, or have dependents, you are better off saving closer to six months worth of expenses. Consider saving this much if the following applies to you:
- You have a lot of expenses (this could include a high mortgage, multiple loan payments, or high vehicle payment).
- You have dependents.
- Your job is not very stable, or if you lose your job you would have a difficult time finding another.
- You are the sole provider.
- You live in an area with a high cost of living.
All of these factors mean that if you have an emergency expense, it might be a very costly one. Experts suggest saving closer to six months’ worth of expenses to give yourself a bigger cushion.
When you should save one year’s worth of expenses:
If you are older and still have a good amount of expenses, it is better to be safe than sorry and save a bit extra. Consider saving this much if the following applies to you:
- You are older or have underlying health conditions.
- You are nearing retirement.
- You have a highly specialized job.
- You are the sole provider to multiple dependents.
Emergency expenses in this case might be pretty costly, so having a year’s worth of expenses will help offset any unforeseen costs and keep you from needing to worry about what could be coming around the bend.
How do you determine your expenses?
It is important to have a good grasp on what your living expenses are every month. You should always have a general idea of how much money comes into your household and leaves your household every month. Creating a budget is a great way to do this. If you need help starting your budget, check out our Beginner’s Guide to Budgeting. To calculate your expenses, start by figuring out the following:
- Your mortgage or rent
- Your utilities (electricity, gas, water, etc)
- Your car payments
- Your insurance payments
- Your loan payments
- Your groceries
- Your medical bills and prescriptions
- Any other monthly expenses (subscriptions, vet bills, etc)
When you add all of this up , you will have a pretty good idea of how much money goes out of your pocket every month. Depending on your goal, multiply this number by 3, 6, or 12 to determine your ideal emergency fund amount.
How do I save for emergencies?
You know how much you need to save, but how do you make that into a reality? Follow these steps to start saving for your emergency fund today.
- Set your savings goal. Calculate your expenses as described above and determine your savings goal. Having a specific goal in mind will help you stay on track.
- Create a budget. Determine all of your expenses for the month as well as all of your income, and look for some places where you can trim some fat. Are there subscriptions that you don’t use? Can you cut back on eating out or takeout? Comb through your budget for opportunities to save.
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- Create an emergency fund within your budget. Start contributing to your emergency fund as if it is a bill you have to pay. Determine how much you can afford per month to set aside, whether it is $10 or $500. As long as you are routinely contributing to your fund it will eventually grow. If you come into extra money throughout the month (think tax returns, a bonus, extra tips, money from a side hustle, etc.) think about investing at least part of it in your emergency fund.
- Put it somewhere safe. It is important to keep your money in a secure place where it can ideally grow and earn interest of its own.
Where should you keep your emergency fund?
When we talk about emergency funds, we might think of cartoon characters keeping their money in a jar above the refrigerator marked “rainy day fund”. But in reality, we are talking about thousands upon thousands of dollars. So where is the safest and smartest place to keep this money? According to financial experts, here are the top four spots to keep your emergency funds:
A high yield bank account
Keeping your emergency money in a high interest saving account is one of the easiest and safest ways to keep your money. It is easy to access when you need it in an emergency, and you may be eligible for a sign-on bonus when you open a new account.
A money market account
Money market accounts are similar to savings accounts, but banks are allowed to invest this money differently so they often offer higher interest rates. You can still easily access your money, but there are often some restrictions (for instance you cannot withdraw money more than six times per month). Additionally, these funds are not insured by the FDIC so you could lose money out of these accounts.
A certificate of deposit
A certificate of deposit offers a guaranteed return at a fixed rate (for example they might offer 1.25% APY for 24 months). These guaranteed rates are usually higher than a savings account or money market account, but your money is tied up for the period of time to which you agree. This means that you may earn more money with this option, but you might not have access to the money when you need it most.
A Roth IRA
While a retirement fund might not immediately come to mind when you think of emergency savings, investing your emergency money in a Roth IRA might be a good move for you. If you invest your funds conservatively, you can make more money than with a traditional savings account. There is a higher risk here however of losing some of your money, so it is riskier than a traditional bank account.
And that’s everything you should know about starting an emergency fund.
While it is impossible to prepare yourself for everything life throws at you, you can certainly try to prepare. Preparing for the unexpected with an emergency fund is a great idea that everyone should consider.
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