Emergency Fund: What It Is And How To Build One

Budgeting for predictable expenses isn't very difficult, but how are you supposed to save money for the costs you don't know are coming? Having an emergency fund can prepare you and alleviate some of the financial anxiety that accompanies unexpected problems.

What Is An Emergency Fund?

An emergency fund is an amount of money saved specifically for unexpected costs. Its purpose is to help prevent you from depleting your savings or going into debt due to unforeseen circumstances. These can be as minor as your car breaking down or as detrimental as falling seriously ill or losing your job. Emergency funds are recommended by most financial experts and are often a hot topic of discussion in personal finance.

Why You Need An Emergency Savings Fund

If your car’s transmission blows and you need $1,000 to fix it, would you have enough savings to cover this expense in cash? If you’re like many U.S. adults, you wouldn’t. According to a 2021 Bankrate survey, less than 40% of Americans could pay an unexpected $1,000 charge with money they have saved. More than one-third of respondents said they'd pay this expense by borrowing.

An emergency fund can keep you from falling into a situation like that. Here are just a few benefits that it can offer:

• Money for car repairs, home repairs, job loss and medical bills
• No high interest charges on your credit card
• No need to take out a personal loan
• No risk to relationships by borrowing from family and friends
• No struggle with debt
• Peace of mind and better mental health

How To Build An Emergency Fund

Setting aside money for emergencies can be stressful, especially if you're already living lean. Here's how you can get started and build up what you need over time.

Calculate How Much You Need

Estimating how much to save in your emergency fund can be tricky. A good rule of thumb, though, is to save from 3-6 months' worth of daily living expenses in your emergency fund. This will help you cover the essentials if you lose your job and need time to get back on your feet.

What counts as living expenses? You'd need to include enough money to cover:

• Your mortgage or rent
• Groceries
• Insurance
• Utilities
• Credit card payments
• Car payments
• Any other essential bills

Focus On Saving What You Can

Don’t be discouraged if you can’t deposit as much as you’d like each month. Say you can only deposit $25 a week into your emergency fund. After a year, you’d have $1,300 saved. If you can boost that figure to $50 a week, you’d have $2,600 saved after a year.

The key is to start saving. Having some money in your emergency fund – even if it won’t cover between 3 and 6 months of living expenses – is better than not having anything saved at all.

Create An Emergency Budget

If you don't feel like you have any room to start saving, try creating an emergency budget to help you build up a safety cushion.

An emergency budget strips all expenses down to the bare necessities only. That means budgeting for your basic needs and financial responsibilities only to severely curb your spending and help stretch your money further to last longer.

Here's what you'll need to do:

• Find or create a budget
• Add up all your expenses, regular and irregular
• Separate expenses into necessary and unnecessary costs
• Cut out all unnecessary expenses
• Try to lower necessary costs
• Reassess your expenses after building your savings

Choose The Right Savings Location

The goal of an emergency fund isn’t to earn money. It’s to provide you with a safety net of cash that you can immediately access. Because of this, you should build your emergency fund in a risk-free savings or money market account. A savings account may be preferable to a checking account because it’ll be harder to use your emergency funds for unnecessary expenses.

If this account earns you, say, 2% interest, that’s even better. But the main goals with an emergency fund are safety and liquidity – not income.

Save Your Tax Refund

A lot of us look forward to getting our checks back from the IRS to cover a purchase on our wish list, but if you don't have an emergency fund, your tax return should probably go into savings. Your refund can be a great way to boost your emergency funds without cutting into your regular monthly expenses.

Use Emergency Money When You Need It

The point of having an emergency fund is to use the money when you need it, so if an unexpected, necessary expense arises, don't be afraid to use your savings. For some of us, it can be difficult to save and save and suddenly see that money disappear – but if you're spending it for its intended purpose, your emergency money is there for you to take advantage of it.

The Bottom Line: You Can Prepare For The Unpredictable

You can't predict the future, but you can be prepared for it. While setting money aside might be difficult, having a financial safety net will pay off down the road – and it will likely help your mental health now, too.

Need help getting started? Take a look at our suggestions for saving money on a tight budget, and focus on making small contributions here and there until you can set aside more.

After your emergency savings are well-established, you can shift your financial goals forward to boosting your credit and building your nest egg for retirement.