Emergency Fund 101: The Basics To Get You Started

There’s no worse feeling than having a major financial set back or to be interrupted as you’re getting your finances on track. When building wealth and getting your financial affairs in order there are a ton of very fun and exciting things to do.

However, many individuals skip over one of the most foundational steps: the emergency fund.

It’s never been more important to have one in order to prevent potentially costly mistakes.

Why Are Emergency Funds Important?

Life is full of surprises. I'm sure you know that by now and if you don't, surprise. I'm sorry to spoil it for you.

There’s truly surprises in life that we can’t possibly plan for and then there are events that are certain to happen but we just don’t know when they’ll happen (i.e. the car breaks down, the air conditioner goes out, etc.) or the magnitude. The latter can, and should be, planned and saved for but the former should be covered by an emergency fund.

Regardless, an emergency fund can help smooth out the impact of an adverse event by preventing a financial set back AND it can give you a degree of peace of mind.

It’s important to note the impact that a financial set back(s) can create. An emergency fund allows the opportunity for you to continue to work your financial plan uninterrupted (or with very little interruption).

In a survey that Bankrate did on emergency fund savings, it found that only 41% of Millennials could cover an unexpected $1,000 expense from savings.

This means that a majority of Millennials are vulnerable and CAN’T cover a large and unexpected expense.

Because life is filled with uncertainties, it's imperative that you adequately protect your personal finances. You may be thinking, "Well that's what insurance is for" and you'd be correct: to an extent.

Insurance companies don't insure everything under the sun. Also, insurance is ideally for those events that are infrequent and are high in severity.

We need something in between. We need something that we can reasonably save and preserve in order to protect ourselves for those times of uncertainty.

Now the more life you live the more you get a handle on what is probable and realistic. You have more clarity on things that are determined to happen. You can save and budget for these inevitable things separately (i.e. car maintenance, home maintenance, events, etc.). If it can be planned for then it should be saved for in advance within your budget, this will take the burden off your emergency fund.

So think of your emergency fund as the safety net that catches what wasn't planned for (because it was unseen) AND what isn't insured. This is a plug to make sure you have adequate insurance coverage in your life.

Note: I will say there isn't anything that you can do to fully protect yourself. Put another way, there's no amount of money in your emergency fund that will offer you complete safety. It just isn't possible.

How Much Should It Be?

This will vary depending on your personal circumstances. If you're struggling to get, and keep, your head above water then get to one month’s worth of living expenses as soon as possible. Why? There's power in hitting a four-figure emergency fund. Also, one month’s worth of living expenses gives you a nice buffer where you have the time to react, adjust, and execute your next plan.

Many Americans have to put a three-figure expense on a credit card because they don’t have the cash to cover it. Plus, an emergency fund worth one month’s of living expenses can handle many different types of uncertainties that may come your way.

If that doesn't feel like enough for an initial emergency fund then you can beef it up a little more. It's a personal decision and thus why it's called personal finance. But be sure to be aware of the financial tradeoffs by doing so. For example, contributing extra to your emergency fund may mean paying less on your high interest credit card debt (if you have it).

Eventually, you want to grow this emergency fund up to an amount that will successfully be able to cover your monthly expenses for a set period of time. The general recommendation is 3-6 months of living expenses (see the diagram below). But again, you may need or want more depending on your financial goals, job, circumstances, and risk tolerance. So it depends.

For example, individuals that don’t have a high-degree of job security, have variable income, or are exposed to more volatility, tend to want and need more cash because they acknowledge that the economic and business cycles trending downward tend to have a greater effect on them. This could be those that work in tech, marketing, event planning or management, project managers, self-employed individuals, contractors, and more.

Whereas, a two-income family with very stable jobs might opt for an emergency fund on the lower end of the spectrum.

You’ll also want to set a timeline for fully funding your remaining emergency fund. This allows you to come to monthly amount you should be saving by your deadline.

For example, if you need an additional $25,000 for your emergency fund and you want it fully funded in 12 months then you know you need to be saving approximately $2,083 per month.

How Do I Start One?

It's easier than ever to start your own emergency fund. If you already have a savings account established at your bank or credit union then you're well on your way.

A high-yield savings account typically pays interest between 10 and 20 times the national savings account average.

If you don't have a separate savings account set up then I'd recommend opening a high-yield savings account with an online bank such as Ally. Even if you already have an account established, it may be in your benefit to check out a high yield savings account for the higher interest rate.

Once you have your account established you will just need to fund it. Fund it with any current savings you already have to get you started.

From here, you can schedule automatic transfers, from your checking account, into this account until it's to your desired amount that you've determined. Auto transfers are nice because you can effectively pay your savings account first before you spending any of your money (i.e. paying yourself first). Out of sight, out of mind.

You may also decide to fund it with a windfall should you receive one because these are infrequent and you likely don't depend on them within your monthly finances. Examples of windfalls would include: an extra paycheck (if getting paid bi-weekly—there are two extra paychecks per year), a tax refund, cash gifts, inheritance, return of premiums, etc.

Remember, we want these funds to be liquid and accessible. In this case, liquid funds should be able to be accessed in a timely manner without penalty or significant loss/change in value.

That's why these funds shouldn't be invested or saved in anything else that is illiquid or volatile (i.e. stocks, CDs, bonds, cryptocurrency, real estate, etc.).

When Should I Start One?

Yesterday. But seriously, if you don't have one then today is the next best option. Even if you aren’t on your own yet (e.g. college student), it’s encouraged to still have an emergency fund built up!

That buffer is crucial in giving you the room to progress, build wealth, and get closer to your financial goals. If you're trying to get out of credit card debt but keep getting hit with unplanned expenses then where do you think those expenses will go? You got it, on the credit card. This how people fail to break out of this vicious cycle.

So not only should you start one today, if you haven't already, but your top priority should be fully funding it. You should continue to make your debt payments and don't stop your retirement saving (especially if you're receiving a match from your employer) while funding this emergency fund.

You’ll likely have to make some sacrifices to make sure it gets funded as soon as possible. But it’ll be worth it.

"The best time to plant a tree was 20 years ago. The second best time is now."

Chinese Proverb

When you look at any company or person that has a well established financial foundation, they haven't reached that point, or remained there, without a reserve of cash for protection and opportunity. This a fundamental truth in building wealth.

Start one today if you haven't already and determine what your initial goal will be for it. Then automate the saving from monthly cash flow and fund it with windfalls when possible. You may have to sacrifice a little in order to get it funded BUT I assure you the added peace of mind and protection is worth it.

By doing these things you'll be able to offer yourself the protection needed to fuel the momentum that will propel you towards your other financial goals, priorities, and building wealth.

Now go and fund that emergency fund!