If you need proof that there are no guarantees in life, just look at what happened in 2020. No one could have predicted a global pandemic, a shutdown, and how it would affect the lives of the people around us and around the world.
But it isn’t just 2020. We're constantly facing unforeseen circumstances, whether it's car breakdowns, home repairs, or unemployment. But even though situations may catch you by surprise, they don't need to catch you unprepared.
I'm going to answer all the questions you may have about emergency funds so you can start building one today for future financial security and peace of mind.
What is an emergency fund?
Let's start with the basics. Put simply, an emergency fund is a financial safety net. It's money that you put aside for life's unexpected events.
Think of it this way: if you live in California, like I do, it's a good idea to have an earthquake preparedness kit. You fill it with basic household items like food, water, and a first aid kit, just in case you need it to survive for a few days.
That's what an emergency fund is. It's not meant to be a long-term or luxurious solution, but it's enough to keep you safe if something happens.
What should I spend my emergency fund on?
An emergency is something that immediately endangers your ability to meet your basic needs. It can include unforeseen medical expenses, major car fixes, and unemployment.
Before digging into your emergency fund, you should ask yourself a few questions:
- Is it unexpected? If it's an expense you know is coming, try to save up for that so that you don't have to remove money from your fund. For instance, a collapsed roof is unexpected. Repainting the living room is not.
- Is it necessary? To manage your finances, you need to draw a bold line between wants and needs. We don't encourage people to completely ignore their wants, but they need to be built into your monthly budget. It shouldn't come out of your emergency fund.
- Is it urgent? If it can wait, then wait. Something like a ruptured appendix needs to be fixed immediately, whereas a procedure like LASIK eye surgery can be put on hold while you build up financial stability.
How big should my emergency fund be?
First of all, if you have any consumer debt like credit card debt, don't worry about building a full emergency fund. You should put any money you have saved toward paying off your debt because those high interest rates will eat away at your savings. In this case, just putting a thousand dollars in an emergency fund is going to get you by for now.
If you're debt-free, then you want to save what your basic needs are going to cost you for three to six months.
If you follow the 50/30/20 budget, then you already spend about 50% of your income on needs. So, to calculate your emergency fund, you're going to multiply that number by something between three and six, depending on how risky you want to be.
How do I start an emergency fund?
You start building an emergency fund by budgeting and saving. It's as simple as that.
If you're following the 50/30/20 method, then you're already putting 50% of your monthly income toward your needs, 30% into wants, and 20% into savings. If you're building an emergency fund, you want to put all 20% of your savings into the emergency fund until it's fully funded.
Where should I keep my emergency fund?
You want to keep your “rainy day” fund somewhere where you can get to it quickly, but not too easily. You want to make sure you can use it when you need to in case of — you know — an emergency, but you also don't want to be tempted to use it on things that are non-emergencies.
That's why we recommend keeping your emergency fund in an online savings account at a different bank than you have your checking account. That way you can get it when you need it, but you won't have to look at the balance when you're checking up on your regular account.
You can't know what's going to happen in life, but that doesn't mean you can't have a plan in place for when something does happen. Starting an emergency fund today will equip you to handle the challenges and uncertainties of tomorrow.