What is an Emergency Fund and Why You Need One?
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When faced with an emergency situation, the last thing you need is to be thinking about how you’re going to manage to cover the costs that come along with it. The best way to avoid ending up in such a stressful situation is to set aside extra money in what is commonly called an emergency fund.
What is an Emergency Fund?
An emergency fund is money that you’ve put away with the purpose of covering any unexpected and urgent costs that may come up.
Your emergency fund should be kept in its own account, separate from the regular savings account that you put money into for your everyday wants and needs.
Why Do I Need an Emergency Fund?
You can’t predict or control what’s going to happen in life, all you can do is try and be prepared for it. Keeping an emergency fund allows you to take care of unexpected costs without derailing your budget or collecting interest charges on your credit card and provides you peace of mind when you need it most.
Simply put, having an emergency fund takes a lot of the stress and anxiety out of a bad situation, allowing you to move forward with a level head.
Loss of Job or Income
No one plans on losing their job, but it can happen to anyone, regardless of tenure or perceived job security. Even those that excel at their job and have held the same position for years cannot be sure that their job will not be eliminated due to technological advances or as a result of downsizing in an underperforming economy.
If you lose your job suddenly, it might take some time to find a suitable replacement at a comparable rate, during which you will need to continue paying your bills. Employment Insurance, severance pay, and unemployment benefits can only go so far, which is where your emergency fund will come in handy.
An emergency fund that covers your cost of living for a few months gives you some breathing room to find your next position without adding to the stress of your situation. This is especially important if you are the sole provider in your household.
A medical emergency can come in many forms: a midnight trip to the emergency room, injuries sustained in a car accident, the appearance of a hereditary health condition, or something less dramatic like a new medication not covered by insurance, a deductible on a necessary procedure, a lapse in insurance, or time taken off work to recover from an illness.
What might appear to be a one-off medical emergency may also reveal itself as a chronic condition requiring a succession of sick days, treatments, and medications. An injury may require long term physical therapy, physical aids, and pain relievers, while a hereditary condition may necessitate serious changes to your lifestyle, regular check-ups and testing, and a regiment of daily medications.
No matter what the situation, costs can add up quickly between hospital bills, treatment costs, and time missed at work. This is a perfect use case for your emergency fund. Whether it’s you or a loved one who needs care, your emergency fund can provide a comfortable barrier when you are at your most vulnerable.
Dental care is not typically covered under standard health insurance, and even if you have an additional dental policy—it is often fairly limited and doesn’t offer coverage for common yet necessary procedures like root canals, wisdom tooth extraction, and orthodontic services like braces and retainers.
Additionally, most dental plans only cover a few hundred to a thousand dollars of treatments each year, which leaves a lot to be desired for a family or someone needing more than the most basic of care. It also means that regardless of insurance, you will likely have to pay for a lot of dental care out of pocket. While not every dental procedure should come out of your emergency fund, it can be a lifesaver when it comes to urgent care.
See Also: How to Retire Early: A Simple and Detailed Step by Step Guide
Dependent Emergency ‘Child or Pet‘
What would you do if you found out your child needed a private tutor to help them tackle a difficult subject at school? Or if they needed to see a speech therapist? Most kids will need a little extra help in one area or another, but providing your child with the resources that they need to lead their best life doesn’t come cheap, and it’s often an ongoing cost.
What about your pet? Animals are a beloved part of the family and they deserve the same care and consideration you would extend to any other family member. Whether your pet is injured in an accident, needs life-saving surgery, or develops a medical condition that requires daily medication, you want to be able to provide for their needs. But vet bills are steep even with pet insurance, while many pet owners don’t have any coverage.
If your child or pet is in need, you shouldn’t have to worry about how you will pay to get them the help they deserve, and if you have an emergency fund, you don’t have to. Regardless of the situation, your emergency fund has you covered, leaving you free to focus on what matters most.
Vehicle Repairs or Replacement
Every vehicle owner has experienced the dreaded day that you go out and can’t start your car, or worse, it starts acting up while you are in the middle of your daily commute. These issues often appear with little to no warning, but they need to be taken care of immediately to keep you safe and on the road.
Car accidents are equally unpredictable and expensive, and they often come with the nasty bonus of raising your insurance premiums and may even leave you with additional medical costs on the side.
Having an emergency fund can help you get back on the road as soon as possible, saving you from paying for ride shares, getting stuck on public transit, or losing income from missed work without having to take on a ton of debt to cover hefty mechanic bills.
Unexpected Housing Costs
Whether you own your home or you are renting, you can never discount the unexpected. You can do everything right and still find yourself having to pay out of pocket for a sudden move or costly home repairs.
As a renter you could face an unforeseen eviction, even if you are up to date on your rent payments, leaving you to deal with the sudden stress and costs of moving. You may need to pay upfront for alternative accommodations if you live in a building that requires substantial repairs or needs to be evacuated for fumigation.
While you might not be facing a surprise eviction if you own your home, you are responsible for all the costs of maintenance and repairs. If you should find yourself with a flooded basement, a water heater that’s out of commission, or with a broken central heating system in the middle of winter, you will want to be able to pay for the replacement or repairs you need, and fast. Having an emergency fund will take these scenarios from a living nightmare to a manageable inconvenience.
Your emergency fund can also be used should you have to replace your belongings in the event of a fire or natural disaster, even if you have insurance as the coverage only goes so far and may take some time to come through.
Emergency Travel and Lodging
If you find yourself needing to make last-minute travel arrangements, you’ll be glad to have an emergency fund to help out with the cost. Flights drastically increase in price when you don’t book in advance, and you might find yourself paying a premium cost to secure a hotel room on short notice, but these things can’t be avoided if a loved one falls ill or passes away.
If you are evacuated from your home for safety reasons or due to a natural disaster, you will not only have to pay for the costs of last-minute travel and lodging, but you’ll probably get stuck paying for a lengthy stay.
Unexpected Outstanding Taxes
Your emergency fund should not be used to pay for expected bills, such as your annual property tax, but it can be a big help when hit with an unexpectedly large tax bill.
It doesn’t matter if the amount owed is on your income or your property tax, you don’t want to mess around with carrying an outstanding amount on your taxes. While you might be able to establish a payment plan for the extra amount, you will be paying a lot on top in fees and interest, making this a great use of your emergency fund.
If you have your identity stolen, you will lose access to some or all of your regular accounts and credit cards while the matter is resolved in order to protect your money. If you are not prepared, this can make a bad situation even worse and leave you scrambling to cover your costs for weeks or even months.
The average cost of a funeral today is $10,000 or more, even with a good life insurance policy you are likely to be left with a significant bill until the benefits kick in, which can take months.
In the event of a loss, your emergency fund can make sure you or your family have one less thing to worry about.
See Also: Why Your Credit Score Matters and How to Improve It
How Big Should My Emergency Fund Be?
When you are just starting out, $1000 is a good milestone to aim for, especially if you have debt, but ideally you should grow your emergency fund to cover three to six months of living expenses, depending on your situation.
If your living situation is stable, you have no dependents, and you’ve held your job long term, you will probably be able to get by with only three months of savings though it never hurts to have a little extra in the bank.
If you are self-employed, the sole supporter of your family, or work on commission, you should err on the side of caution and aim for six months of savings.
It is also a good idea to aim for a larger emergency fund if you or someone else in your household is living with a chronic illness as a safeguard against potential loss of income or unexpected medical costs. Even if you account for these expenses within your regular budget, having a little extra set aside in your emergency fund can make a world of difference when costs add up to more than you expected.
To ensure you save the right amount, you need to make sure you account for all of your expenses. We recommend including a little extra on top of your necessary expenses to give you some room in your emergency fund should you need to use it.
How Do I Establish an Emergency Fund?
There is no secret formula to saving money. However, there are some ways to fast track your emergency fund.
Set a Savings Goal
Your savings goal should be the amount you intend to set aside for your emergency fund, though you may set it lower when you’re starting out, or break it down into a series of smaller goals to provide you with a sense of progress along the way.
As we mentioned before, you will generally want to aim to cover your cost of living for three to six months with your emergency fund, so you could set your savings goal at the full amount, or perhaps set savings milestones at the cost of living per month.
Develop a Budget
With your savings goal in mind, you can begin to create a budget to help you reach it. You’ll want to set aside whatever you can spare from your monthly income after your cost of living is covered, and perhaps consider temporarily diverting half of your monthly savings allotment into your emergency fund to get it started.
Putting money into your emergency fund should be one of your top priorities until you reach your savings goal as it is your buffer against the unexpected, without it you could find yourself in a tight spot if anything should happen.
To figure out how much you can afford to save each month, you’ll need to figure out the total amount of your monthly income and expenses, and then categorize and review them until you’ve separated your wants from your needs. From here you will begin to look for areas that you can reduce your expenses in to add more into your savings.
Reduce Your Expenses
To help you reach your goal as soon as possible, look for costs in your lifestyle and monthly budget that can be reduced or cut out completely. This has the added benefit of leaving you with more free money once you’ve established your emergency fund that can be put into your regular savings to help you achieve other financial goals.
Most people have a number of financial leaks in their monthly expenses, which can be resolved and directly contributed to savings, but you likely also have room to reduce your non-essential expenses, and may even be able to cut down some of your monthly bills including groceries and utilities.
You can use apps like Trim to help you find opportunities where you can cut expenses.
Increase Your Income
There are lots of ways you can increase your income, of course, you can always ask for a raise or take on more hours at your 9 to 5, but if that’s not an option for you, don’t fret! There are plenty of other ways to bring in some extra money on the side, more than a few choices that suit your abilities, needs, and schedule.
One option is to take on a part-time job or pick up shift work, and with all of the work on-demand apps available today it’s easier than ever.
If you have a car and enjoy socializing, you might consider signing up with a ridesharing app like Uber or Lyft. If driving sounds like a good job but taking on passengers doesn’t appeal to you, why not pick up some shifts with a food delivery app like DoorDash or Postmates? You could also sign up to be a personal shopper with a grocery delivery service like Instacart, or deliver packages part-time with Amazon Flex.
No car? No problem! There are plenty of ways to bring in money fast without ever leaving your home.
No matter what your talents or qualifications, you can put them to use and bring in extra income selling your services online. Whether you like to write reviews, draw, or build websites in your free time, there is someone looking for your services on a freelancing website like Fiverr, Freelancer, or Upwork. Set up a profile, set your price, and get to work… it’s that easy!
See Also: How to Pay Off Student Loans Faster Than Ever
Pay Off Your Debts
Putting money towards getting out of debt instead of into your emergency fund might seem counterintuitive but it actually sets you up for saving more in the long run by cutting out the interest charges. It also frees you from the stress of owing money and cuts an extra cost out of your monthly budget, which is a huge relief in any situation where you need to rely on your emergency fund.
Keep the Change
Putting your spare change into a piggy bank or change jar designated for a rainy day is a great way to steadily contribute to your savings account without extra thought or effort. Adding to this, you can easily grow your emergency savings by automatically throwing in the money you get from things like returning your recycling.
If the majority of your purchases are made with a debit card, you may want to look into the ‘Keep the Change’ service offered by your bank. Many banks have an option to automatically round all of your purchases to the nearest dollar and deposit the difference directly into your savings account.
Save Your Tax Refunds
It might be tempting to indulge with the money you get back after filing your income tax, but putting the money directly into your savings or emergency fund will serve you much better. Remember, your income tax refund isn’t a windfall of free money, it’s the return of money you overpaid in taxes, money that otherwise would have been a part of your regular budget.
Assess and Adjust
One of the most important things to do when making any changes to your budget or savings plan is to take the time to review and adjust your strategy along the way. When you are first getting established with a new budget or savings plan, you should be reviewing your finances against it as frequently as once per week, with a more in-depth review at the end of each month.
Don’t be hesitant to make changes as needed, your budget should be working in service of your financial goals and meeting your needs. As you get comfortable, you can limit your budget review check-ins to once a month, but if you make big changes be sure to switch back to more regular reviews.
Tips for Success
Now that you know what an emergency fund is and how to setup one, It’s now time to make the most of it.
Keep it Liquid
When the time comes that you need to use your emergency fund, you will want to be able to access it quickly and easily.
Keep the funds in a savings account which you can access through a debit card as well as with cheques, so no matter what you need the money for, you can put it to use without difficulty.
While your funds should be accessible, it’s a good idea to keep them separated from your regular accounts so that you do not use them by accident and are not tempted to put them towards non-emergency purposes.
See Also: 21 Fast, Proven and Effective Ways to Save Money
Set Up a Short Term and Long Term Fund
Once you have a decent amount of money put away, you should consider splitting your emergency fund in two. Creating a short term and long term emergency fund allows you to get the best return on the money you have saved without keeping it out of reach when you need it.
Your short term emergency fund should be kept in its own savings account that you can access immediately should you need to, while long term emergency fund may be tucked away in investments or an account that provides you with higher returns but takes longer to access.
Set Up Automatic Deposits
You might be surprised at how easy it is to put money away once you’ve automated the process. Setting up automatic deposits for your emergency fund saves you the trouble of having to manually transfer the money each time you get paid, and it can make it easier to save by taking the money off your mind.
If the funds are automatically deposited, you are less likely to count them as part of your income, and as a result you won’t be as tempted to dip into the money for other purposes.
What Doesn’t Qualify as an Emergency?
A simple way to tell if something is truly worth dipping into your emergency fund is to ask yourself the following questions:
- Is the expense unexpected?
- Is it an absolutely necessary expense?
- Does the situation need to be resolved urgently?
If you answer yes to two or more of these questions, you are probably dealing with an emergency, but use your discretion. If you are honest with yourself, you probably know that the great deal on that new TV you’ve been wanting doesn’t really qualify as an emergency, but flying out to see your sick grandmother in the hospital does.
An emergency fund is truly one of the most important things you can have in your financial portfolio. It doesn’t just cover sudden expenses, it provides you with peace of mind when you need it most, and removes a lot of the stress from what is already a difficult situation. Having an emergency fund gives you the financial freedom you need to provide your family with the best possible care and standard of living while keeping you out of debt and on track with your budget, and that’s something you can’t put a value on.
Ricardo is an entrepreneur, investor and personal finance nerd who enjoys spending time with his family and friends, travelling and helping others achieve their financial goals. Ricardo has been quoted as a personal finance expert in several online publications including Healthline, Bankrate, GOBankingRates, MSN Money, Yahoo Finance, U.S. News & World Report, Forbes and USA Today.