Emergency funds

An emergency fund is more than a rainy-day fund. It’s a necessary part of your financial life — one that can help you avoid major financial problems that come from unplanned expenses.

In This Lesson

Save enough to cover unexpected expenses and gaps in income

Keep the money in a checking or savings account or CD

Use this fund for real emergencies, not to pay for splurges

What is an emergency fund?

An emergency fund is the accessible cash that you always keep on hand, so you won't need to run up credit card debt or dip into your retirement accounts or investments, if something unexpected crops up. It won't literally be in cash, but it'll be someplace that makes it easy to get your hands on it, such as a checking and savings account or CDs.

Why do I need an emergency fund?

The name is a little misleading because not all of your cash needs are necessarily emergencies. But some of the biggies are definitely in that category, such as:

Medical expenses that are not covered by insurance
Major car repairs
Unexpected home repairs
Unemployment, or if self-employed, gaps between jobs or projects
Drop in income due to temporary disability or injury
Last-minute but essential travel, for a funeral or illness
Missed paycheck from a bank error or other snafus

Based on bankruptcy statistics, credit card debt, medical expenses and job loss are significant factors in bankruptcies. While some of the circumstances leading to these bankruptcies were unavoidable, having a decent buffer of cash can minimize your risk of being put in that kind of financial stress.

If you don't leave enough money sitting in easily accessible places, any of these situations can trip you up. You might turn to a credit card that might take months (or years) to pay off — costing you hundreds of dollars in interest charges. If you lose your job and have no accessible savings to bridge you to the next one, you might decide to cash in your 401(k) or IRA, wiping out your retirement savings (while possibly losing half of it to taxes and penalties). Keeping adequate cash in your easily liquidated accounts avoids these kinds of risks.

How much do you need in an emergency fund?

In the beginning, your emergency fund should be enough to give you a small cushion in your bank account at the end of every pay cycle. We recommend building up to $1,000 to start, which is the same as saving about $19 per week for a year. That will cover a lot of car, medical or home expenses that might come up.

Given its purpose, there's no magic number for how much to keep in an emergency fund. Many find that the right amount is enough to cover three to six months’ worth of expenses, but it varies based on your lifestyle factors.

In order to know this amount, you’ll have to set a budget that tracks your income, expenses, debt, savings and discretionary income.

Here are some factors to think about for coming up with the right number for you:

Job security

This is top of the list because job loss leads to the worst-case scenario: No income to pay your living expenses. There are two extremes. Some jobs are more secure, with little risk of losing your income suddenly, such as some government or unionized jobs. In contrast, a freelance writer might routinely go months without any income. The longer you might have to go between paychecks, the bigger your emergency fund needs to be.  

Health insurance

If you don’t have health insurance, you need to get it. Even the smallest medical procedure can cost you thousands if you’re uncovered. If you have a high-deductible health plan, you need to keep money set aside (ideally, in an health savings account) to cover a few thousand dollars of out-of-pocket expenses, such as deductibles before your insurance company kicks in a dime. Other health insurance plans, such as ones through your employer, require only minimal co-payments. If you don't have health insurance, the sky is the limit on how big an emergency fund you need because a minor accident could easily run up tens or hundreds of thousands of dollars in unexpected medical bills. (The message here is don't go without health insurance.)  

See also: Health insurance

Car choices

If you drive an older car and have an unexpected car repair, spending $300 on a major repair can be hard. Having an emergency fund helps pay for these expenses so put aside a little extra to cover these costs. If you drive a newer car, you may not need extra money for repairs right away.

Home repairs

Water heaters break, roofs leak and Mother Nature delivers a hurricane and an earthquake in your neighborhood in same week. These things really do happen. Your homeowners insurance may cover some of these costs, but you almost always need to pay a deductible. So you’ll need to save up money for each of these cases — requiring a bigger emergency fund.

See also: Homeowners insurance

Disability

If you have a higher-risk occupation or have health risks, you may go without income for an extended period. You can buy disability insurance to protect yourself against this, but if you don't, it can factor into your emergency fund. You need to ask yourself how much you want to prepare for this kind of scenario.

See also: Other insurance

How do I start building an emergency fund?

You don't have to build your emergency fund overnight — trying to save a large amount in a short period of time can be too overwhelming. Instead set goals by following these general tips for how you can start building your emergency fund:

Make it a priority.

An emergency fund isn’t one of the last things you should be doing every month — it’s one of the first. Make adding to your emergency fund as a monthly savings expense on your budget. Try making it as mandatory as your gas or utility bill.

Start small.

Even if you can’t afford to chip in thousands of dollars right off the bat, get started with regular small sums. It will give you the momentum to keep saving, and you’ll enjoy the positive reinforcement of watching the account grow over time. Start by storing your emergency fund in your checking account. After you have your $1,000 safety net, you can start putting more emergency funds in a savings account. Once your money really starts to grow, you’ll want to consider other investment options. The key is to start saving and leave this fund alone unless you actually have an emergency.

Automate your emergency savings.

As with any other kind of saving, we recommend that you set up automatic transfer of any emergency fund money from your checking account into savings account until you reach your goal six month's worth of expenses or more (some experts now are recommending 12 month’s worth of savings). After that, you can stop contributing, as long as you don't touch the money. If you end up using it for an emergency or for another reason, make sure that you put back into emergency savings what you took out. Try not to fall under that three months' of expenses threshold. And, if you're lifestyle gets more expensive, remember to increase your emergency fund amount.

Don’t risk it.

An emergency fund isn’t to be put into the stock market. It’s to be kept in safe account like plain old savings accounts, so it’ll be there when you need it. Avoiding unnecessary gambles with that critical cash will also help you sleep better at night.