The term “emergency fund” refers to money set aside to be used in times of financial distress. The purpose of an emergency fund is to improve financial security by creating a safety net for unanticipated expenses, such as an illness or major home repairs.
Assets in an emergency fund are typically cash or other highly liquid assets. This reduces the need to either draw from high-interest debt options, such as credit cards or unsecured loans, or compromise future security by tapping into retirement funds.
Key Takeaways
- An emergency fund is a financial safety net for future mishaps and/or unexpected expenses.
- Emergency funds should typically cover three to six months’ worth of expenses, although some experts now suggest up to one year’s worth.
- Funds should be kept in accounts that are easily accessible and easily liquidated.
- Tax refunds and other windfalls can be used to build up the fund.
- Some employers have programs to encourage emergency fund saving.
Understanding Emergency Funds
Creating an emergency fund involves setting aside money intended for use during times of financial hardship. This includes job loss, debilitating illness, or major repairs—situations similar to the economic crises encountered in recent years.
The ideal size of an emergency fund varies based on individual financial situations, expenses, lifestyle, and debts. Financial advisors generally recommend saving enough to cover three to six months’ worth of expenses, which can help manage unexpected healthcare bills or brief unemployment.
Some experts advocate for even larger funds. For instance, finance guru Suze Orman suggests saving enough to cover eight months’ worth of expenses—a viewpoint emphasized by recent economic downturns.
Individual needs dictate the specific savings level. For example, a single adult without dependents may be comfortable with three months’ expenses, while a sole breadwinner for a family might aim for six months or more. However, many are far from this goal: A 2020 survey by the Federal Reserve found that more than a quarter of Americans lacked enough savings to cover a $400 expense, with this figure rising to 45% among unemployed workers.
If living paycheck to paycheck, start with modest goals, like putting 2% of your net income into the fund and gradually increasing contributions. Even a modest safety net can provide some relief in a financial crisis. Avoid depleting the emergency fund for non-essential expenses.
How to Build an Emergency Fund
Starting early is crucial for setting up an emergency fund, as it helps build a cushion against future emergencies. Here are two simple methods to begin saving:
- Set aside part of your salary every month. Calculate your living expenses for a specific period and set that amount as your emergency fund goal. Divert a portion of your paycheck—through an automatic transfer—to that account each month. Once the fund is sufficient, consider investing additional savings for the long term or other goals.
- Save your tax refund. Instead of using your tax refund or stimulus check for discretionary spending, consider diverting it towards your emergency fund.
Park your emergency fund in an account that can be easily liquidated. While a savings account is the safest option, there are other secure ways to store part of your emergency fund with better interest-earning potential, like high-interest savings accounts, money market accounts, and no-penalty certificates of deposit (CDs).
Building an emergency fund should precede entering volatile investment vehicles like stocks. These investments offer more significant long-term growth potential but can suffer in value during economic downturns, risking a larger loss should you need to liquidate them during a crisis. An emergency fund helps protect your portfolio against such risks.
Tip
Want more advice for saving money? Explore additional financial planning resources.
Helping Employees Save
Several major employers have introduced programs to promote emergency savings:
- Truist Financial Corp.: Offers $750 to employees who complete an eight-part financial education program and open and fund an emergency savings account.
- Levi Strauss & Co.: Matches up to $240 in savings contributions over six months through the Red Tab Foundation, plus a $20 bonus for linking a bank account to their online platform.
- Prudential Financial Inc.: Allows employees to divert part of their paycheck toward a savings account, creating a financial safety net while preserving retirement contributions.
Example of an Emergency Fund
Here’s a hypothetical example: A married couple with monthly expenses totaling $5,000 (including mortgage, food, car payments, etc.) should aim to set aside at least $15,000 for three months ($30,000 for six months or $40,000 for eight months).
How much should I have in an emergency fund?
Aim to eventually save three to six months of living expenses, adjusted according to your specific costs.
How can I create an emergency fund if I am living paycheck to paycheck?
Set a manageable percentage of your take-home pay to save each payday. Focus on consistent saving rather than the total amount. Even small contributions add up.
What is an emergency fund for?
An emergency fund is for unexpected bills that can’t be paid immediately. Avoid using it for non-essential expenses.
Related Terms: financial distress, liquid assets, credit cards, retirement funds, tax refunds.
References
- Consumer Financial Protection Bureau. “An Essential Guide to Building an Emergency Fund: What Is an Emergency Fund?”
- Navicore Solutions. “Why Everyone Needs an Emergency Fund and How to Start”.
- Suze Orman. “Emergency Fund 101”.
- Federal Reserve System. “Report on the Economic Well-Being of U.S. Households in 2020 — May 2021”.
- SnoCope Credit Union. “The 3-6-9 Rules Guidelines for Emergency Savings”.
- Experian. “How to Build and Use an Emergency Fund”.
- Federal Deposit Insurance Corp. “Your Insured Deposits”.
- Truist. “Truist Momentum”.
- PR Newswire. “Truist Answers the Call for Financial Literacy for All”.
- Red Tab Foundation. “The Red Tab Savers Program: A Free, Online Savings Tool for LS&Co. Employees That Rewards You for Saving Every Month.”
- Prudential Financial. “Total Rewards Brochure: The Prudential Employee Savings Plan”, Page 3.
