Most of us have all experienced large and unexpected expenses, such as a medical emergency, an unplanned vehicle repair, a necessary home-appliance replacement, or even job loss.
Unfortunately, most of these financial emergencies happen when least expected. They also derail our financial plans, especially if we don’t have enough money saved to pay for them.
According to The Motley Fool, the Federal Reserve has reported that “39% of Americans don’t have enough money on hand to cover a $400 emergency.”
By building a rainy day fund, you can protect yourself and avoid being part of this group. When these financial emergencies arise, you will also be able to recover quicker and get back on track towards achieving your larger financial goals.
In This Guide:
- What an emergency fund is
- Why it’s so important to have an emergency fund
- How much you should have in an emergency fund
- Where to put your emergency fund
- Steps to build your emergency fund
- Putting these steps into action
- Emergency fund example
- When you should use your emergency fund
What Is an Emergency Fund?
The term “emergency fund” or “rainy day fund” refers to money that’s set aside that people can use to cover for large and unexpected expenses or financial emergencies.
Using an emergency fund to cover these unexpected expenses is far better than paying for them with a high-interest credit card or taking out a personal loan.
Here are a few emergencies people use their rainy day fund for:
- Job loss
- Unexpected medical or dental expenses
- Unplanned vehicle repairs
- Necessary home-appliance repairs
- Unforeseen living expenses
- Funeral expenses
The general guideline is that you should only use your emergency savings for large, unplanned payments or bills that are not part of your typical monthly spending and expenses.
Why It’s Important to Have an Emergency Fund
Not only is it important to have one, an emergency fund is an essential part of any sound financial plan.
Without an emergency fund, any large and unexpected expense could set you back financially. It could also bury you in debt, and this debt could potentially have a long-lasting impact on your financial health.
Simply put, your emergency fund will create a large budget buffer that will keep you afloat during a financial emergency and prevent you from having to max out a credit card or take out a high-interest loan.
How Much Should You Have in an Emergency Fund?
The amount of money you should save for your rainy day fund will largely depend on your individual situation. However, most financial experts recommend saving a minimum of three months’ worth of expenses.
Saving this amount may take some time, so make a small goal at first, such as saving $500, and then work your way up to a reserve that can cover three months’ worth of expenses.
While the three month benchmark is a wonderful start, your long-term savings goal should be an emergency fund that can cover at least six month’s of expenses.
If you’re a business owner, a sole breadwinner, or a person with a variable income, you may even want to aim for 12 month’s worth of expenses.
According to the consumer expenditure figures released by the U.S. Bureau of Labor Statistics, the average annual expenditure per consumer unit was $63,036 in 2019.
We have broken this data down to three months, six months, eight months, and twelve months in the table below to help you get a better visual.
The visual shows the recommended amount the average household should have in their emergency fund depending on how many months they want their fund to cover.
As you can see, even an emergency fund of just three months’ worth of expenses is quite a lot. In fact, your first reaction may have been that it’s too much for you to come up with.
Why Such a Large Amount?
The amount of money to have a sufficient emergency fund is definitely a lot. However, with the uncertain times and uncertain economies we live in, especially with the coronavirus pandemic, job security may be a thing of the past.
Unemployment can always happen unexpectedly and it tends to be at the worst possible time. However, even in the absence of a pandemic, financial emergencies such as unexpected medical expenses or unplanned vehicle repairs can be quite costly and there’s never a good time for them to happen.
While you may not have an extra $15,759 sitting around, it’s all rather relative. Even a year worth of expenses is nothing compared to how much you should save for retirement.
When compared to how much money you will spend over the course of the next few decades, a few months’ worth of expenses really isn’t all that much.
Where to Put Your Emergency Fund
Once you have calculated how much to save for your emergency fund, you need to decide where to keep it.
This will largely depend on your situation. However, you want to make sure it’s somewhere that’s accessible, safe, and hopefully earns a little bit of interest.
It should also be somewhere that you won’t be tempted to spend it on things that aren’t emergencies.
Keep in mind, having your emergency fund accessible and not at risk in the market is far more important than the amount of interest you earn.
Considering these factors, the ideal place to keep your rainy day fund is in a high-yield savings account.
10 Simple Steps to Build Your Emergency Fund:
Once you’re prepared to start building your emergency fund, there are necessary steps you need to take.
For example, the first step is to start with your budget, which is the biggest step in the process. The rest of the steps will be relatively simple and easy. Following them will help you grow your emergency fund savings with little to no headaches.
Keep in mind that starting the process early is fundamental to building your rainy day fund. You never know when unexpected financial emergencies will arise, so it’s important you start now.
1. Start with your budget
It’s important that you create a budget if you don’t have one. Your budget will help you discover opportunities to save. Without a budget, it will be hard to maximize your income and manage or even reduce your spending.
You may even want to take it a step further and use a budgeting app. These apps will automatically calculate your income and spending. This will allow you to have an overview of your financial situation in one place.
2. Set an emergency fund goal
Setting a specific savings goal will help you stay motivated and make saving less daunting, especially when your first getting started. The best way to do this is by transferring funds into a savings account every time you get paid.
To determine this number, look at your budget and calculate how much money you need each month to cover your essential expenses, such as rent or mortgage, utilities, food, transportation, and any other necessary budget category.
You can use a savings planning tool to help you calculate how long it will take to reach your emergency fund goal, based on how often and how much you’re able to save.
3. Use direct deposit
There are many different ways to save. However, setting up automatic recurring transfers is by far the best and easiest.
If your employer offers direct deposit, it’s highly likely they can take a portion of your paycheck and automatically deposit it into your savings account.
This way, your monthly savings goal is taken care of without you even having to think about it.
4. Put aside unexpected income
There will be certain times throughout the year that you receive an unexpected windfall, such as a cash gift, bonus, inheritance, or even an economic impact payment.
Consider saving this unexpected income and put it towards your emergency fund, instead of spending it on things you want but don’t need.
5.Save your tax refund
If you expect a tax refund, you may be tempted to see it as extra money for discretionary spending, such as entertainment.
Instead, have your tax refund deposited directly into your savings account to go towards your emergency fund.
6. Save your change
There are many mobile cash back apps you can use to save automatically every time you make a purchase.
These apps will round up the purchase amount of your transactions. This extra amount will then be automatically deposited to your savings account.
If you frequently use cash to make payments, just put the spare change in a jar at home and then once it fills up, take it to the bank and deposit the change into your savings account.
7. Slowly increase your savings
Are you consistently accomplishing your savings goals? If so, I highly recommend you slowly increase the amount you’re contributing, over time, by a few percent or a specific dollar amount.
There’s a high chance you won’t even notice this small increase in your rainy day savings missing from your checking account and it will help you reach your goals quicker.
8. Continue saving
There are many emergencies that may require more than a three, or six-month cushion. Considering this, I recommend you continue saving until you have enough to cover 12 months’ worth of expenses.
If one of these situations occur, you will be very relieved to have this extra money in your emergency fund.
An example of these situations include being in the hospital for many months or being unemployed for over a year.
9. Frequently monitor your progress
Find a way to check your emergency fund at least once a month to see how much you’re saving and make necessary adjustments if needed.
If your emergency fund is in a high-yield savings account, you can request that your bank sends you an automatic notification of your account balance once a month.
Not only will this help you stay on track, seeing your progress will give you encouragement to keep going.
10. Celebrate your wins
Did you achieve your savings goal for the month? If you did, make sure you take time to recognize what you have accomplished. Find simple ways that you can celebrate if you have reached your goal, and then set your next one.
Putting These Steps Into Action
Ideally, you should treat your monthly savings goal for your emergency fund just like another recurring bill you’re required to pay each month. Dedicate a certain amount from your paycheck and set it aside every time you’re paid.
Unfortunately, many people have no problem regularly sending huge amounts of money to credit card companies, but are hesitant to pay themselves first. don’t fall for this mindset.
If you haven’t built your emergency fund, there’s no better time than now to start saving.
Emergency Fund Example
Here is a hypothetical example showing how to calculate how much you will need to save for your rainy day fund.
Let’s say a single woman has monthly expenses of $4,000, which includes her rent payment, vehicle payment, food expenses, and any other necessary bills.
Using the six-month rule, she should save $24,000 in her emergency fund to cover for any large and unexpected expenses.
If she decides to use the three-month rule, she should save $12,000, or $32,000 if she uses the eight-month rule.
When You Should Use Your Emergency Fund
As previously mentioned, you should only use your emergency fund for large and unexpected expenses or financial emergencies. To determine what constitutes a financial emergency, set some guidelines for yourself.
For example, not every unplanned expense is going to be a dire emergency. Even if it’s a quick trip to an urgent care center, it may not make sense to use your cash reserves to pay for it.
However, try to stay consistent with what you do and don’t consider a financial emergency.
Emergency Fund FAQs
Is $5,000 a Good Emergency Fund?
It’s better to have some money saved for emergencies than nothing at all and $5,000 is a wonderful start. However, a $5,000 emergency fund can only pay for so much.
While deciding how much you should save for financial emergencies, consider different situations where you may need to use your funds.
As previously mentioned, these include unexpected medical expenses, unplanned vehicle repairs, job loss, or anything else that can derail your financial plans that is unexpected.
How Much Should I Put in my Emergency Fund per Month?
The amount you should save for your emergency fund per month will depend on your savings goal. For example, if you want to save $16,000 for your fund within a year, you will need to save approximately $1,333 per month to achieve your goal.
If you have an idea of how much you want to save for your emergency fund and how long you want it to take, simply divide the total amount by the number of months to calculate how much you should save per month.
Should I Use my Emergency Fund to Pay off Debt?
Are you struggling with a lot of debt? If you have some money saved, you may be considering using it to become debt-free, or at least pay a lot of it off.
While becoming debt-free is a wonderful long-term goal, an emergency fund is designed to be used for emergencies only.
Considering this, I highly suggest you only pay extra towards your debt once you have established a well-funded emergency fund.
In fact, if someone had a lot of debt and no emergency fund, I would recommend they make minimum payments on their debt while they build an emergency fund, and then start paying extra towards becoming debt-free.
This way, your emergency savings will act as a safety net to prevent you from going further into debt from unexpected financial emergencies.
Final Words on Emergency Funds
You should consider your emergency fund an insurance policy and once you have saved enough, guard it safely.
Keep in mind that it’s not your piggy bank. You should never use these funds for small and expected expenses or bills.
Only use your fund in the event of an unexpected financial emergency and spend it carefully when you do. Once you spend it, it will takes several months to replace it.
As your financial situation changes and your salary increases, make sure to add to your emergency fund so it matches with your new situation.