What is an emergency fund?
Without even realizing it, most people are familiar with protection-first thinking. Every time you ride in a plane, for example, you hear this important safety announcement: “In the event of sudden decompression, secure your own oxygen mask before helping others.” When it comes to your finances, this means building layers of protection to ensure you stay on track for your long-term financial goals. An emergency fund is a crucial layer of this protection.
Whatis an emergency fund?
An emergency fund is money that you set aside to use only for unexpected financial emergencies, like medical bills or to repair a vehicle. An emergency fund is your first line of defense against unexpected events and the first key component of a financial strategy.
Why do I need an emergency fund?
Emergency funds protect you and your loved ones from the unexpected. Prioritizing protection can feel counterintuitive, especially if you have debt to pay off. People have the good intention of wanting to reduce their debt as quickly as possible, but what happens if you have a sudden, unexpected event? In this case, there’s a good chance you’ll turn to credit cards or personal loans — and go deeper into debt. As a result, this sudden expense will have a much longer impact on your financial life. While eliminating debt is important, building an emergency fund is critical, and the good news is, with careful planning and budgeting, you can do both at the same time.
Financial emergencies happen
Financial emergencies are hopefully infrequent, but they happen. Consider this list of potential emergencies: job loss, accidents, long-term illness that stops your income, home or car damage or natural disaster. It doesn’t take long to think of someone you know who has faced one of these crises in the last year. Everyone thinks, “It won’t happen to me,” but an emergency can happen to anyone.
Many Americans are unprotected
Even when people understand that an emergency can occur at any time, the majority are not protected. In fact, only 44 percent of Americans have $1,000 in savings for an emergency. Many people say they would have to turn to credit cards, friends or family, or personal loans to pay for it, putting them in the black hole of debt.
Are you a spender or a saver?
Further, many people want to put savings aside, but their behavior with money does not support this financial goal. According to the 2021 Guardian Study of Financial and Emotional Confidence, 50 percent of American workers said one of their top financial priorities is to build savings for any reason. Yet, two-thirds of the same group said that they are “spenders rather than savers,” reflecting the disconnect between people’s financial goals and actions. Additionally, 37 percent said they avoid dealing with their finances all together because it overwhelms them.2
How to start an emergency fund today
Every journey begins with the first step, and this is certainly true with building your emergency fund. To start, set your savings goal. A round number like $500 can be a good first step, but after that, some experts say you should aim to save six months of living expenses. And even that may not be enough, financial professionals say the ideal is to save the equivalent of one year’s worth of income. This amount of money can be used to help with emergencies or to cover expenses if you lose your job, saving you from going into debt.
Where to put an emergency fund
Put your emergency fund into a savings account. Savings accounts earn interest on the money you deposit and are protected by federal insurance up to $250,000. If you have consistent income, consider setting up an automatic deduction from your paycheck into your savings account. If your income is inconsistent, as a freelancer for instance, make a pact with yourself to set aside a certain percentage of everything that comes in. The minimum recommendation is 10% of your income, which can be increased over time as you become more comfortable with paying yourself first. The goal is to get in the habit of saving — and in the habit of protecting your long-term financial health — so you can be prepared for whatever life may bring.
How to jumpstart your emergency fund
One easy way to start your emergency fund off right is to use an upcoming windfall payment to start a nest egg. Most Americans receive a tax refund after paying their federal income tax — consider using your next refund as the beginning of your emergency fund. Similarly, if you receive an annual bonus at work or anticipate another large, lump sum payment, consider putting that money into your emergency savings instead of spending it or using it to make a lump sum payment towards debt reduction.
When to use an emergency fund
Emergency funds should be used only in the event of an unexpected financial emergency. Don’t dip into your emergency for everyday expenses like groceries or entertainment. And when you do have to spend your emergency funds, make sure to replace them as soon as possible.
How to further protect your finances
Think of your emergency fund as a financial oxygen mask: by putting your own financial protection first, you’ll be able to cover unplanned life events and take better care of those your love. Once you’ve established your emergency fund, the next step is to put layers of protection in place, such as getting the right insurance, to protect your progress and your loved ones.
Layers of protection
Prioritizing an emergency fund and protecting yourself — even before paying down debt — is a strong financial strategy. Layering protections like whole life insurance, a health savings account (HSA), and disability insurance can help keep your lifestyle safe and prevent you from going into debt or taking on more debt. Talk with your financial professional about the best plan of protection for you and your loved ones for the long term.
1 56% of Americans can’t cover a $1,000 emergency expense, CNBC, Jan. 19, 2022