What Is an Emergency Fund?

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What Is an Emergency Fund?

An emergency fund is an account set aside to gather money for emergency use. The emergency itself may be anything, but it’s wise to plan for the worst, which means loss of your ability to earn income. Conventional wisdom says to save for three to six months’ worth of your daily expenses, though others suggest more, especially during periods of economic uncertainty. This includes rent, mortgage, major bills, food, etc. Paradoxically, you tend to need an emergency fund the most when you’re not financially stable, like when you’re just starting out, which is when it is the most difficult to save. Emergency funds are something that you can’t create overnight. It can take a year or more to build a fund sufficient to meet your minimum emergency needs and years to build up a more robust amount of savings. Some people add to them over the course of years instead.

Use existing money if you can

Ideally, you want to pay for emergency expenses with existing funds. Though credit will do the job as well as cash in your savings account, it comes with expensive strings attached. Interest on credit cards, just like the interest on savings accounts, adds up over the months, so you end up paying off a bill higher than what you originally incurred. In addition, credit card companies may levy extra fees or higher rates if you go over your limit or forget to pay your bill, adding to the overall cost. An additional advantage of using existing money is that it can earn interest or dividends if sitting in an account in a financial institution.

First, track your expenses

You should know your spending and earning habits well enough to decide how large of an emergency fund you’re going to need. If your income is not stable—which is true for many self-employed consumers—you may need a larger fund than someone who gets a steady paycheck does. Begin by determining how much money you spend in a month, including housing-related expenses, utilities, car payments, gas, insurance, food, and loan payments. Since a loss of income-earning ability will mean cutting out unnecessary expenses during that time, focus on the necessary ones. Once you have your total dollar amount, multiply it by the number of months you think you’ll need. With this goal in mind, determine a safe amount to sock away each month or week. At first, it’s probably best to set aside a small amount, but be consistent with it.

Start small

Don’t be discouraged if the amount you need to save seems impossibly large. With the help of budgeting and automatic savings plans, you can begin saving a small amount. It’s beneficial to even have one month of expenses in an emergency fund versus nothing. And as you get pay increases, tax refunds or cash gifts, you can sock away more, increasing the size of the fund over time.