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I’m sure that you’ve heard this before, but it bears repeating: when you’re getting your financial house in order, your first step should be to build up an emergency fund.
An emergency fund helps you get through financial rough patches in your life — broken washing machines, unexpected medical bills, and the like — without derailing the rest of your financial plan. The keys are to have this fund built up before disaster strikes and to save it for true emergencies.
Here, we’ll talk about how much to save in an emergency fund, how to save it, and when it’s okay to dip into those funds. We’ll also talk about emergency fund alternatives, including a home equity line of credit.
How large should your emergency fund be?
Your emergency fund goal will depend on your individual circumstances. Most financial gurus suggest an emergency fund that will cover three to six months of living expenses, though some are comfortable with less and others recommend more. Still others, such as Dave Ramsey, suggest a tiered approach where you initially set aside $1,000 and then build up a larger emergency fund after eliminating your debts.
If you have other serious financial goals, such as getting out of high-interest debt, the last option may fit your needs best. With that said, your initial emergency fund may need to be smaller or larger, depending on your circumstances.
Learn More: Where Should I Keep My Emergency Fund?
For instance, if you have a family and know that medical emergencies could be more likely to arise, you may need a larger initial emergency fund. If you make more than you spend nearly every month, though, you could divert some of your extra funds to paying for emergencies. So a smaller emergency fund, like $500, could set you up.
What if you’re already out of debt or, at least, don’t have any debts with super-high interest? In this case, you’ll need to decide whether it’s more important to pay off your remaining debts or save more in your emergency fund. This will depend on your individual financial goals, and your tolerance for risk.
With that said, when you do start building a larger emergency fund, you’ll need to look at a variety of factors when deciding how much to save, including:
- The likelihood that you’ll lose your job. If it’s more likely, save more money.
- You family’s earning potential. If you’re a two-income family, you may be able to get by with a smaller emergency fund. With one income, you’ll want to save more.
- Demand in your job field. If you work in a high-demand area where getting re-hired would be simple, you may be able to have a smaller emergency fund. If finding a new job would take a while, build up more.
- Potential large expenses that you could incur. If you’re a renter, for instance, you may get by with a smaller emergency fund because you won’t have to do any unexpected home repairs. Those are your landlord’s job. But homeowners need larger emergency funds to deal with potential housing problems.
As you can see, figuring out how much you need to save for emergencies can be difficult. When in doubt, though, you can always start on the low end of three months’ worth of expenses, and then work your way up if you feel like you need more.
How Do You Calculate Your Expenses?
One thing to remember, though, is that when we talk about an emergency fund, we’re talking about your expenses, not your budget. Your budget should include things like dining out, traveling, family vacations, clothing, fun activities, home improvements, and more. Your actual expenses, though, don’t necessarily include these things.
In this case, we’re considering your expenses to be your bare-bones budget. If a true emergency required you to stop all unnecessary spending, how far down could you strip your budget? Your must-pay expenses include, in order of importance:
- Basic, necessary groceries and household supplies
- Rent or mortgage payments
- Basic utilities (not including cable, Netflix, etc.)
- Transportation expenses to get to work or job interviews
- Child care costs if you need it while you work or job hunt
- Necessary personal supplies (like toothpaste) and essential clothing
- Minimum debt payments
Look at your budget, and figure out how much those things honestly cost you on a monthly basis. That’s your one-month emergency fund goal. So if a month’s worth of expenses for you is $2,500, a three-month emergency fund would be $7,500.
How should you build an emergency fund?
Even though deciding on your emergency fund goal can be a bit confusing, the really hard part is actually building up that emergency fund. How do you decide between competing financial goals to save money for your emergency fund? Or where do you get that money from if you’re already living paycheck to paycheck?
For one thing, you should know that it takes time to come up with the money for your emergency fund. It may take you several months or even a year or more, even if you’re disciplined at saving. Several months’ worth of expenses is a lot of money, after all!
But this is definitely a worthwhile financial goal. In fact, having an emergency fund in place can help you more quickly meet other financial goals, like investing or starting a business. Knowing you have some cash padding helps you be more comfortable taking risks, which are essential for growing both personally and financially.
Resource: 31 Greatest Money Rules of Thumb
With all that said, here are some options for building your emergency fund:
- Build it into your budget. You may have heard of the “pay yourself first” principle. Look at your budget, and decide how much you can afford to put towards your emergency fund each month. Then, set up an automatic transfer to put that amount into a separate savings account each time you get paid. If you never have access to that cash, you’re much less likely to spend it frivolously!
- Put windfalls into your fund. When you receive a gift of cash or an unexpected inheritance, consider putting that money right into your emergency fund. This is an excellent way to reach your goal more quickly, without the pain of trimming your budget.
- Stick your tax rebate into savings. Many Americans choose to use their tax refunds to pay for vacation, but you could be smart and save yours, instead. Transfer at least most of the balance into a savings account, and you’ll have an excellent start on your emergency fund.
- Trim a specific expense. Think of one unnecessary expense you have, like picking up coffee each day instead of making it at home, or dining out. Commit to giving up that expense for a few months, and instead put what you would have spent into your savings account.
- Use the one and done method. Alternatively, find ways to trim bigger bills, like your mortgage or cable bill. When you cut back on these expenses, put the money you’ve saved straight into your emergency fund.
How Will You Spend Your Emergency Fund?
One of the most difficult things to establish when thinking about an emergency fund is how you’ll actually spend it. What, exactly, constitutes an emergency?
Well, that’s going to depend on your individual circumstances, again. But here are a few things that are and are not a financial emergency:
An emergency is not . . .
- A broken TV or other entertainment device. Your TV breaking can seem like an emergency, but it’s not worth dipping into your emergency fund for. Instead, when your TV or computer (that you don’t need for money-making work) breaks, start saving up to get a new one. In the meantime, find other ways to entertain yourself.
- Lack of planning. So, you forgot to account for all of your auto-paid bills, and you can’t grocery shop this weekend without overdrafting your account? It’s time to dig into the pantry and figure out how to eat for next to nothing while you wait for your next paycheck. It’s not time to tap your emergency fund.
- Your washing machine breaks. This may or may not constitute an emergency. If you’re in an area with no laundromats and you can’t take your laundry to a friend’s or family member’s house, you may need to fix the machine ASAP. But if you have other options for doing your wash, consider using them while you save up to fix the machine.
An emergency is . . .
- You lose your job. This one’s a true emergency. If you lose your job, strip your budget to the bare essentials, and cover spending with your emergency fund while you look for a new one.
- Your car breaks down. This one is a little like the washing machine, but it’s more likely to be an emergency. If you depend on your car to get to work, tap the emergency fund to cover repairs so you don’t lose your job. However, if there’s public transportation in your area, consider sucking it up and using that, even though it’s less convenient.
- Your roof is leaking or furnace breaks. Some household issues are true emergencies, especially if they’re safety hazards or will become more expensive and difficult to fix if left alone. Use your emergency funds to pay for these types of repairs.
- You have a medical or dental emergency. You should definitely pay for medical or dental emergencies, but be sure you budget to cover annual exams and dental cleanings to make these things less likely.
What are Some Other Emergency Fund Options?
So, what happens if an emergency arises before you’re able to save an emergency fund? In this case, you’ve got a few options for covering emergency expenses. None of them is as good as using cash, but they’ll do in a pinch:
- Interest-free credit card. If you have good credit, you may be able to access a credit card with a 0% interest introductory fee. This can be a good emergency fund, temporarily. Just be aware that applying for and receiving the card will take some time. And you’ll want to repay the balance as quickly as possible.
- Home equity line of credit. HELOCs still have historically low rates, so you could leave one open while you’re paying off high-interest debt to act as an emergency fund. It’s there if you need it, but you don’t have to use it. Just keep in mind that your home is acting as security in this case, so be sure you handle this debt extra responsibly.
- Personal loan. Taking out a personal loan can come with high interest unless you have excellent credit. But it can be a way to access quick cash when you need it. Again, though, you’ll want to pay off this debt as quickly as possible after taking it out.
Be sure that if you use one of these other options, you only do it in the absolute most necessary emergencies. Your criteria for tapping into debt should be even stricter than your criteria for spending regular emergency savings. That’s because once you tap into the debt, you not only have to save up for your emergency fund, still, but you also have to pay back the debt.
An emergency fund is definitely an essential piece of a financially responsible life. How will you start saving yours?