Emergency Fund: Uses and How to Build Yours

What Is an Emergency Fund?

An emergency fund is money set aside to cover unexpected expenses. Setting up an emergency fund provides you with a financial safety net whenever you come across unforeseen circumstances, including day-to-day expenses after a job loss or unexpected medical bills, among other things.

An emergency fund should be set up in an easily accessible vehicle if the need arises. Your emergency fund should never be used to pay for nonessential expenses, but it should be replenished whenever it is used.

How Emergency Funds Work

Emergency funds can be helpful to cover everything from everyday expenses after a job loss or drop in income, or paying for emergency medical bills, home repairs, and other financial emergencies. The shock from these (and other) sudden costs can be devastating, which is why it’s important to set one up.

Not having an emergency fund can be stressful, disrupting your other savings and the potential for increased debt. That’s because when an emergency arises, you may have to rely on other savings vehicles, such as a vacation fund or retirement accounts, or debt like credit cards and loans.

The amount of money you hold in your emergency fund depends entirely on your situation and goals. However, most experts suggest keeping three to six months of expenses in savings to help you when you need it. So, how do you get there? Make sure you understand how income changes and unforeseen situations can impact your life and set realistic goals. Try to save small amounts to help you reach that amount.

How to Build Your Emergency Fund

Building an emergency fund requires time and discipline, so it does require some work on your end. We’ve outlined some of the basic steps below to make it a little easier to achieve this goal.

1. Set your goal. While you can’t anticipate the cost of an unexpected car repair or medical expense, adding up your monthly expenses can help you determine how much to save. So if your expenses are $1,000 and you want to set aside three months’ worth, you’ll have to save $3,000.
2. Determine how much you can save. Saving may seem tough if you’re living paycheck to paycheck, but it isn’t impossible. Setting aside a small amount—even $25 per paycheck—can help. If you use cash, any small change can also go into your fund.
3. Look for other ways to save. Ask yourself if you can make cuts in certain areas, including discretionary spending. This is nonessential spending, such as dining out, entertainment, and subscription services. For instance, consider canceling your gym membership if your condo complex has a facility or cutting down the number of days you go out to eat each week.
4. Review your progress. Do a regular check-in to see where you are and how close you are to reaching your goal. This can help keep you on track.

Increase your emergency fund contribution whenever possible. Resist the urge to spend any unexpected money you get and put it into your emergency fund, at least until you reach your goal. This includes money from a raise, a bonus, or a birthday check from your parents.

You should also make sure that you refill your account anytime you have to access it.

How to Keep Your Emergency Fund

Your emergency fund should be housed in a liquid account. This means putting the money into an account or vehicle that you can easily access without having to jump through hoops or incur fees and penalties.

The following are a few options you may want to consider:

• High-yield savings account: Different types of savings accounts are available through banks, credit unions, and online account providers. If you go for a high-yield savings account your balance will continue to grow because of the interest offered by the provider.
• Money market account: A money market account offers the benefits of a checking and savings account but limits on the number of withdrawals each month. Although restrictive, this can reduce the temptation to use the account for any other purpose.
• Cash envelope: You can put physical cash in an envelope in a secure location. But this method won't accrue interest, and you may be tempted to use the money for other reasons.
• Prepaid card: You can load your cash onto one or more prepaid debit cards. Since prepaid cards aren’t linked to a bank account, you won’t disrupt your checking or other savings accounts. But you also won't be earning interest on that money.

When to Use Your Emergency Fund

Having an emergency fund is just one step to achieving your financial goals. However, knowing when and when not to use this cash reserve is also important. The following are some of the reasons why you may end up relying on your emergency fund:

• You lose your job or have a sudden drop in pay
• An unexpected medical or vet bill
• Repairing your car
• Emergency home repairs

Do not use your emergency fund for everyday expenses, traveling, impulse purchases, debt payments, or investing.

Remember: The purpose of your emergency fund is for you to use the money in dire circumstances, so don’t be afraid to use it when the need arises. Just be sure that you replenish your fund after you’ve tapped into it.

Example of an Emergency Fund

Let’s say you want to set up an emergency fund and decide to save four months of expenses in a savings account. You determine that you have the following obligations each month: