An emergency fund is a separate bank or savings account you only use for major emergency situations. Common examples of a major emergency include sudden unemployment, making a major home repair, recovering after an accident or paying for medical expenses. Emergency funds are important because they allow you to cover the emergency without having to take out a loan or racking up credit card debt.
If you want to start an emergency fund, there are several different methods you can use. You are rarely able to start your emergency account right away. Instead, you begin with an initial investment in the account and gradually fill it up until you hit your goal. When you make a major expense, such as buying a new house or car, you may need to update your emergency account to reflect the value of your new purchases. For example, the funds needed to replace a new car are typically much higher than an older vehicle.
Setting an Emergency Fund Goal
Calculating emergency fund needs is different for each individual. If you do not have any existing savings, start with a three-month fund. A 3 month emergency fund must be able to cover your major expenses, such as rent, utilities and insurance, for a three-month period. You can start with the account with only a few hundred dollars, but dedicate a percentage of your paycheck each month to add to the account until you hit the three-month goal.
Extra emergency savings are recommended if you have a family, since your expenses cover more than yourself. Starting a 6 month emergency fund provides a larger safety net, ensuring your family does not suffer while you recover from a crisis.
While emergency money is important, you do not want to go overboard with saving. Calculate your average expenses each month and compare this to how much you make. Also take into consideration other expenses you are saving for. Be flexible, otherwise you risk creating an unnecessary situation where you must dip into your emergency funding.
Creating a New Account
The average emergency fund is stored in a high-yield savings account. These are specialized accounts with massive interest rates, causing your emergency funds to increase in value faster than a traditional bank account. These accounts have stricter requirements, including your initial deposit as well as the minimum balance you must maintain.
Keep monitoring your emergency fund, even after you hit your goal. This not only gives you an idea of whether you need to invest additional funds after a major life change, but it also lets you keep up with any changes to the bank’s interest rates. If the rates start to drop, you may want to move your funds into a different account.
Tiered Emergency Savings Account
A tiered emergency fund is a more complex method of saving money. With a tiered plan, your emergency funding is stored in different locations. The first part of a tiered fund begins with the cash you have on hand. Your cash on hand should be enough to cover one to two days of expenses.
The next emergency savings tier is your cash at home. This refers to general savings you can access at any given point. This amount should total enough to survive for at least three to six months. The next level is a high-yield savings account, similar to what you would have for a traditional emergency account. In a tiered system you only need emergency money for two to three months of savings. The next level is liquid financial assets. This refers to your ability to sell any assets on short notice to generate money. You want enough assets to cover at least five months of expenses.
The final part of a tiered emergency fund is your long-term investments. Your long-term investments refers to any significant asset that takes longer to liquidate, such as real estate. This is only used in the direst of circumstances.
Saving emergency funds in a tiered system is more complex than a traditional emergency account. However, it gives you a much better idea of your overall finances, since you are saving on multiple levels. It also requires you to actively track your finances for the later tiers. Because it is more complex, it takes longer to start a tiered system. A tiered emergency fund is much more common for families than individuals.
Creating an emergency fund is not easy, but there are several methods that simplify the process. A popular option is to set up a direct deposit account, so a portion of each paycheck is automatically placed in a high yield interest account. This process works best if you already have a basic savings account to work on. Otherwise, you may find yourself constantly accessing your emergency savings account to cover your normal expenses.
You may be able to start an emergency fund through your employer. Some companies provide benefits for retirement. Instead of depositing all the money into a retirement account, ask if you can split the money. It is important to make the distinction because retirement accounts typically have strict requirements on when you can access the funds. While there are options to use it in an emergency, you may have to pay additional fees to withdraw the funds.
Another option to build up emergency money is to contribute large influxes of cash, such as your tax return or a holiday gift. If you do not have many cash influxes throughout the year, consider using one of them to create a base for your emergency account, then switch to a different method to keep it funded.
The last option to build an emergency fund is managing your cash flow. This method involves the most work, but grants the greatest control over how you save. When you manage your cash flow, you break down your weekly finances and set aside a small portion of your funds each week to create an emergency account. This is similar to directly depositing a portion of your paycheck, but because the process is not automated, you have more control over your finances. It also makes tracking your emergency savings easier, since you are directly depositing the money each time.