What it’s for.
Unsurprisingly, your emergency fund is for emergencies. If you remember the Great Recession – or even if you’re trying forget it – jobs were both hard to keep and hard to come by. Of course, this didn’t mean that regular monthly expenses went away too. However, leading up to the recession, Americans were saving a dismal amount. This meant that if you were someone who lost a job or whose spouse lost a job or who both lost their jobs and then had to start looking in a tightening job market for replacement income, you may not have had an emergency fund to cushion the blow.
Your emergency fund is there to cover those regular monthly expenses that are just part of what it costs to live. And if you make a list of your regular monthly payments, you may realize that it costs a lot more than you expected. You need a roof over your head. You need to cover the costs of transportation. You need to eat. You need to turn on the air conditioner in the summer if you’re in the South and heat your home in the winter up North. You need electricity and water and garbage pickup. You need health insurance. You need to stay current on debt payments.
And, sure, if after you look over your monthly expenses and decide that it seems like they’re just a little more of your budget than you think they should be, then, hey, what a perfect time to start changing your lifestyle. It’s probably easier to make your lifestyle more efficient NOW rather than trying to make that change when you have lost your job. Use your A/C less, ride a bike, get a roommate.
A rule of thumb for the size of your emergency fund advises that the amount you’ve saved should be enough to cover 3 to 6 months of living expenses. Of course, harking back to that time in life called the Great Recession…many people were unable to find a job that replaced the income they lost in 3 months. So, start with the goal of 3 months and build.
Likewise if you’re active in today’s job market, you may have noticed that sometimes it takes 3 months to even hear back from a job you’ve applied for.
What it’s also for.
Your emergency fund is also a place to look for cash to cover large, unexpected expenses such as new tires for your car. You may not have expected to run over a nail and that it would go in both the front and back tires, but it’s not as if you can just keep driving on flats.
And if you’ve added a fluffy friend to your life – let’s say a dog named Timber – then you know as well as I do that he is going to get sick and you are going to have to take him to the vet and the vet it going to give you a sizable bill and you are going to look at Timber’s big brown eyes and realize that your money might as well belong to him. If you give a mouse a cookie, right? So, you’re probably going to need to dedicate a portion of that emergency fund to him.
What it’s not for.
Your emergency fund is not for last minute vacations or Cyber Monday sales. It’s just not.
You may be thinking, “Well, you said an emergency fund should cover what it costs to live, and what it costs to really live includes buying tickets to the NCAA College Football National Championship Game because Roll Tide.” And to that, well, have a separate savings account for these types of expenses. You need to enjoy your life. You don’t want to be all ant and no grasshopper. But, if you’re out of a job, you’re likely to be more concerned about keeping up on your car payments so that it doesn’t get repossessed than you are about cheering for the team in person.
Of course, you don't have to start with saving $500 a month. This is just an example. If that seems overwhelming, and you don't have room in your budget or that big of a chunk of your paycheck, start with $50. Move up to $75 if you don't notice it. The important thing is to start.
Likewise if you tally up your monthly expenses, and you find yourself breaking out in hives, relax. It's just a rule of thumb. Instead, aim for saving $1,000 in your emergency fund. Work your way to this amount. Once you're there, target $3,000, then target $5,000. $5,000 is a sizable amount to have waiting in the wings.
Remember, the emergency fund is a tool to help make your life easier and to make the unexpected less traumatic. If it's stressing you out, lower your monthly contribution to an amount that works for you. And breathe.
When to do it.
The prime time to start stocking away money for your emergency fund is now. The next best time is with your next paycheck.
If your employer offers a match in your retirement plan, you want to take advantage of this feature – it’s free money! What’s a match? The best way to explain it is with an example. If your employer offers a 3% match to your retirement, this means that if YOU contribute 3%, your employer will contribute 3% too. They’ll match what you put in – and the employer’s portion is not included in your paycheck.
I mention the match to arrive at the following: if you don’t have an emergency fund, you should prioritize this before saving the full amount for retirement (16.6%, rule of thumb) EXCEPT for the portion you need to contribute to your retirement plan in order to receive the match. And you might be curious and ask, “Well, why does it matter if I’m saving in an Emergency Fund versus my retirement account? They’re both mine, right?” If an emergency arises, and you need cash immediately, you do not want to have to take the money out of your retirement account. Your money is in this account to grow tax-free until you need it for retirement. Taking the money out means it’s not growing anymore, and the withdrawal is taxed AND comes with a penalty if withdrawn before you are 59 ½ . You should not treat retirement accounts like savings accounts. The money needs to grow to make it less likely that you will need to look for a way to receive a paycheck when you’re 80. 80 may seem like a long way off. That’s great! Think of how long your money will have to sit, invested and UNTOUCHED, growing and compounding over those decades. So, hands off. If you need to access money, look instead to that emergency fund.
If your employer doesn't offer a match, you should still contribute to a retirement plan. You can set one up yourself. Start with the monthly contribution of 3% of your salary. If you don't start right away, chances are you will be pretty late to the game when you do finally get around to prioritizing retirement savings. Do a little.
How to make it happen.
Now that you’re convinced that you will sleep better if you have an emergency fund, how should you make it a reality? Well, now that you’ve written out your regular monthly expenses and have an idea of just how much is left over in your monthly budget, you know what’s available to save. And this might not be as much as you’d like. But, the best way to build your emergency fund is to start with a reasonable amount of each of your paychecks. If you get paid twice a month, set up an automatic draft to come out of your paycheck and immediately transfer into your savings account. Making the funds come out automatically lets you off the hook. Now you don’t have to make the effort to save. It’s happening whether you remembered to do it or not.
After a month or two, if you feel like you can raise the amount you’re moving over, do it. Once you feel like your emergency fund has enough to cover you for 3 or 6 or 12 months – whichever makes you comfortable – you’re set. (And now instead of cancelling that bank draft from your paycheck to your savings account, you can just switch it to move from your paycheck to your retirement account!)
Great opportunities to make large contributions.
Contributing monthly to your emergency fund may seem like a slow go. Of course, there may be times each year when you have the opportunity to make large deposits into the account. Tax refunds and bonuses are excellent times to make bulk contributions to your emergency fund.
And if it bums you out to get that tax refund check and turn around and put the whole thing in your emergency fund, then do what most people do: split it. Put half in savings and treat yourself with the rest. After all, you aren't just working to pay the bills. You're also working so that you have the funds to take a trip. So take a trip.