Starting an Emergency Savings Fund
Everyone knows that saving money is an important part of achieving financial goals like buying a house or saving for retirement. There’s more to it than that, though, as saving money is also an essential step in preparing for life’s emergencies.
Unfortunately, a distressing number of Americans aren’t saving money for emergencies. According to one Bankrate study, 28% of U.S. adults have no emergency savings at all. CNBC also reported in 2019 that 60% of Americans couldn’t cover a $1,000 emergency without going into debt.
While it can be difficult to save when you’re on a tight budget, committing even a small amount to an emergency savings account each month can help you work toward a safety net.
How Big Should Your Emergency Fund Be?
The size of your emergency fund depends in part on your living expenses. When calculating how much to save for an emergency fund, strive for an amount that covers at least three to six months’ worth of living expenses.
You want to save enough money to cover the cost of living during a worst-case scenario, such as completely losing your income source. This could happen if you lose your job or if you face other severe financial difficulties. Ideally, you’ll provide yourself enough time to recover your income without going into debt in the process.
For example, if your base expenses for housing, food, utilities and other essentials cost about $2,000 per month, you’ll want to save at least $6,000 to $12,000. Most people won’t be able to save amounts like these immediately with the cash they have on hand, but you can work toward them with monthly installments. If possible, you should also consider saving more for predictable costs like vehicle repairs.
Where to Keep Your Emergency Savings?
There are few options as to where you can keep your emergency fund so you can access it when you need it. In most cases, a standard checking account for emergency savings won’t cut it. Instead, look for a banking product that will accrue the most amount of interest over time.
It may be tempting to invest your savings in the market to gain a higher yield, but according to John Noonan, principal partner of Great Oak Capital Partners, that’s not a great idea.
“You should never risk an emergency fund, a short-term account, by putting it in the market, which is long-term by nature,” he explains. “For a little interest while it sits there, bank CDs and high-yield savings accounts are typically the most appropriate.”
Standard savings accounts usually come with an annual percentage yield (APY) of under 0.10%, and many banks pay rates as low as 0.01%. High-yield savings accounts typically come with an APY ranging from 1% to 2% or higher.
You could also stash your fund in a money market account, which pays interest based on the interest rates in the money markets. Funds saved in these accounts are insured by the FDIC and can potentially earn you a high yield, although it depends on the market.
Money market accounts are also more liquid when compared to other products. Most of your funds would be available for withdrawal whenever you need it. The one downside to a money market account is that it usually require a high initial deposit.
Finally, you could consider putting your money in a certificate of deposit (CD) account, but keep in mind that you can’t withdraw funds from a CD without a penalty until it reaches its maturity date. That means that you could lose some of your savings if you encounter an emergency and need to make an early withdrawal.
How to Build Your Emergency Fund?
The easiest way to build an emergency fund is to set up recurring, automated monthly transfers to a high-yield savings account or money market account. This way, you don’t have to consciously put money aside each month — even the savviest investors struggle to do this consistently. Try to treat your emergency savings transfer as a regular monthly expense.
If possible, follow the 50/30/20 rule. Put 50% of your income toward necessary expenses like housing, food, and bills. Then, put 30% of your income toward “wants” and 20% toward your savings. If you’re feeling particularly frugal and you have the funds, you can rearrange these percentages to save even more.
To determine how long it will take to put aside three to six months’ worth of expenses, you can use a savings calculator. Ideally, you’ll want to build your emergency fund as soon as possible, but it could take several months depending on your expenses.
Should You Invest Your Emergency Savings?
You should certainly take advantage of other investment opportunities, but not before building your emergency savings in a risk-free account that you can access without penalty.
Many investment products come with risk — even the potential to lose all your money. If you invest your emergency savings in the stock market and lose most of it, for example, you could be put in a bind if an emergency arises at the same time. Other investment products can also be risky if you need to make a withdrawal.
“It is unwise to invest in anything until your emergency is at least half-funded,” says Noonan. “Otherwise, premature IRA withdrawals, 401k loans and racking up debt to cover unforeseen expenses all create bad habits and can be costly, be it through taxes, penalties or high-interest rates.”
The Final Word
Building an emergency savings fund should be the first financial move you take before investing your money elsewhere. High-yield savings accounts are ideal for this purpose. Ideally, you should save enough to cover three to six months worth of expenses.
Saving isn’t always easy, especially if you’re living paycheck to paycheck. But putting just a little bit aside each month is all that’s necessary to work toward your savings goal. Consider setting up automatic recurring payments to your savings account to stay committed. Once you’ve established an emergency savings fund, you’ll have a safety net should the worst come to pass, and you can start focusing on other financial goals.