Building an emergency fund is critical as life tends to throw things your way when you least expect it. Although emergencies could range from a job loss to a medical emergency or anything in between, you’ll usually need some cash on hand to handle the situation with minimal stress. That’s where an emergency fund can come in handy.
The definition of an emergency fund
An emergency fund is there to help you through difficult situations. Since you never know what life has in store, a solid emergency fund can prepare for whatever comes your way.
You should only use the funds in a true emergency with an unplanned expense. A few things that might pop up to otherwise destroy your budget include a major car repair, a medical issue, a job loss, a family member in need, and many more. The emergencies that life throws your way are often stressful enough without having to worry about how you are going to pay for it. Instead of taking on debt to pull yourself out of a situation, you can rely on this stash of savings to handle the financial impacts of the emergency.
The savings you keep in your emergency fund should be completely separate from any other savings goals. For example, let’s say you are saving up for a home downpayment. Those savings would be separate from an emergency fund.
How much should you have in your emergency fund?
Having cash on hand to cover unexpected situations sounds like a great idea. But how much of an emergency fund should you have on hand?
Most experts recommend stashing between 3 to 6 months worth of living expenses in your emergency fund. For example, let’s say you spend $3,000 per month. That means you would need to have between $9,000 to $18,000 safely tucked away.
However, the final decision on how much you should have in your emergency fund will depend on your personal risk tolerance and employment situation. If you have a highly volatile income, then you might need a bigger emergency fund. If you have a more stable income, then you might feel more comfortable with a smaller emergency fund.
How long should it take to build an emergency fund
The idea of an emergency fund sounds great. But building that cushion of savings can take time. So how long will it take you to build your emergency fund? The answer depends on your savings rate.
If you have an extremely high savings rate, then you might be able to meet your goal within a few months. But it could take longer if you have a lower savings rate.
How to build an emergency fund
Take a look at your budget and your income. Then set a reasonable timeframe to meet your emergency fund goals. With a goal in mind, you’ll be better prepared to make steady progress.
If you want to accelerate your progress, then you can either increase your income or decrease your expenses. Let’s take a closer look at those options.
Increase your salary
You might find several opportunities at your current job to increase your income. Look for overtime and promotion opportunities to boost your income. You can also ask your supervisor for a raise. But make sure to come to the conversation with information that shows why you should receive a raise.
Pick up a side hustle
If you aren’t able to increase your salary, then you always have the option of picking up a side hustle. The best part about a side hustle is that there is no limit to your earning potential. You could pick up a few hours of extra work or eventually turn your side hustle into your primary source of income.
Slash your biggest expenses
The average American spends the vast majority of their income on five major expenses – housing, food, transportation, healthcare, and taxes. Luckily, there are ways for you to dramatically reduce these expenses and free up some space in your budget.
One of the biggest expenses to slash is your housing expense. With the help of house hacking, you have the potential to live for free! Imagine how that could dramatically impact your savings rate.
Pause discretionary spending
Beyond the necessary expenses in your life, you likely have some room in your budget for discretionary spending. That might include money for dinners out, vacations, and more. You could put a hold on these expenses until you reach your emergency fund goal.
Depending on your discretionary expenses, this strategy could dramatically speed up your progress.
Where to put your emergency fund
An emergency fund is there to help you when you need it. With that, it needs to be in an easily accessible account. Plus, it should have a very low amount of risk associated with it.
Another factor is that these funds should be separated from your everyday spending account. Otherwise, you might accidentally spend your emergency savings.
With that, the best option is usually a high yield savings account. You don’t want to park savings of this size in a regular savings account because the funds will essentially never grow. A high yield savings account offers the opportunity to grow your savings at a slow but steady rate with the option to access the funds at any time.
The bottom line
An emergency fund is a critical part of a solid financial foundation. Although there will be financial setbacks on your journey to financial freedom, an emergency fund can help you buffer any storms that come your way.