You may be familiar with the concept of an emergency fund, and you may have heard some of the rules of thumb about them. But emergency funds can be the bedrock of your entire financial plan. Because of that, we want you to go beyond just rules of thumb. We want you to feel confident your emergency fund is set up properly and matches your personal needs.
In this article, we’ll cover what we believe to be the most important aspects of emergency funds.
- What is an emergency fund?
- What are the benefits of having an emergency fund?
- How big should your emergency fund be?
- How can I build my emergency fund?
- Where should I keep my emergency fund?
The goal is to give you the tools you need to help build a bullet-proof emergency fund for your personal situation. Let’s get to it.
What is an emergency fund?
An emergency fund. A safety net. A rainy day account. Whatever you call it, an emergency fund is a pool of money you save in case you are faced with an unexpected financial burden.
It should be specifically set aside for emergencies, such as a car repair, medical problem, or plumbing leak. Your emergency fund can also help you weather through an unexpected loss of income like a job loss or cut in hours.
An emergency fund should not be used unless absolutely necessary. It should never be used for discretionary spending, like going out to dinner or a vacation. Think of those fire extinguishers that say “in case of emergency, break glass.” That is the feeling you should have when you go to withdraw from your emergency fund. If the expense isn’t essential, think twice before dipping in.
What are the benefits of having an emergency fund?
In case you aren’t already convinced, we’ve identified three key benefits of having an emergency fund.
1. Avoid Unnecessary Debt
Having an emergency fund can help you avoid unnecessary debt. When an emergency happens to you (it’s only a matter of time), not having money set aside usually leaves you with very few options, none of them good.
In fact, according to the Report on the Economic Well-Being of U.S. Households in 2017, “four in 10 adults, if faced with an unexpected expense of $400, would either not be able to cover it or would cover it by selling something or borrowing money.” As far as emergencies go, $400 is a relatively minor expense. A car repair or hospital visit could easily exceed that amount.
The same report goes on to state that amongst the 40% of Americans who would have trouble, “the most common approaches to handle the expense include carrying a balance on credit cards.”
This is part of the reason 43.9% of U.S. families have credit card debt, with an average balance of $5,700 according to the Federal Reserve Board’s triennial Survey of Consumer Finances (SCF).
With the average credit card interest rate for 2018 at 14.22%, that means the average American is paying $810 in credit card interest every single year!
Simply having an emergency fund can help save you from high-interest debt when Murphy’s Law comes knocking on your door.
2. Peace of Mind
When you are always worried about how you’ll possibly pay for the next [fill in the blank], your mind can be in a constant state of stress. The 2017 Stress in America survey found that money was the 2nd most common source of stress in the U.S.
Human beings crave safety and security. In fact, according to Maslow’s Hierarchy of Needs, safety needs (physical safety, financial security, etc.) are second only to physiological needs (food, water, warmth, etc.).
An emergency fund can help you build financial security, thus allowing you to focus on other things such as relationships, charitable giving, and self-development.
Image Source: Simply Psychology
3. Financial Flexibility
Lastly, having an emergency fund can give you the financial flexibility to switch jobs if you are unhappy.
The same stress survey listed above showed that work was the 3rd highest source of stress in the country, right behind money. Do you feel trapped at your current job, but can’t leave because you are living paycheck to paycheck?
An emergency fund can provide the financial buffer to leave your job and find one that is more rewarding, or even provide some startup money for your entrepreneurial adventure.
Whether it’s giving you security during a job hunt, getting your business up and running, or unexpected moving costs to your new job in a new city, an emergency fund can give you the flexibility to take steps you otherwise wouldn’t be able to.
How big should your emergency fund be?
Nobody can predict the exact timing or cost of future emergencies you will face, which makes determining the proper size for your emergency fund difficult. However, we can use some concrete data points to get a starting point, and then adjust that to match your particular situation.
Losing your job is one of the most expensive emergencies you are likely to face, so this is a good starting point for calculating the proper size of your emergency fund.
According to the United States Bureau of Labor Statistics, last month’s median duration of unemployment (seasonally adjusted) was about 10 weeks. So on average, it will take you a little under three months to find a new job.
That means a good starting point for your emergency fund balance should be three months of expenses.
Notably, this is right in line with a statement from the Report on the Economic Well-Being of U.S. Households in 2017 which states “one common measure of financial preparation is whether people have savings sufficient to cover three months of expenses if they lost their job.” Sadly, the report goes on to mention that only “half of people have set aside dedicated emergency savings of this level.”
If you’re unsure what three months of your spending is, Betterment will calculate it for you using your gross income, zip code and research from the American Economic Association and the National Bureau of Economic Research.
Data source: Betterment analysis of self-reported income and estimated tax rates; American Economic Association; National Bureau of Economic Research. The chart shows assumed rates of spending, savings, and effective taxes for a single individual with no additional information about location, actual savings, or Social Security benefits. The default location is Colorado, which is roughly equivalent to the U.S. national average for cost of living and state taxes.
With this as a base, you can begin to customize your emergency fund balance to match your situation. The following are some examples of why you should adjust your emergency fund balance.
- Your income isn’t stable: Sometimes you may need to dip into your emergency fund, even if you haven’t lost your job. If you are in sales or some other commission-based job where your income can fluctuate, it can be a good idea to add a few months to your safety net.
- You are the sole/primary income earner: If you are the sole breadwinner in your family, losing your job could be catastrophic to your family’s finances, more so than if your spouse also works. If you are the sole income earner, the loss of your job could mean that your family has no income at all. If that’s the case, consider increasing your emergency fund by a few months.
- Your expenses may not be adjustable: If a large expense or income shock occurs, would you be able to quickly cut back on other expenses? If a lot of your expenses are fixed and unable to be reduced, consider adding a month or two to your emergency fund.
- Your personal risk tolerance: Lastly, always adjust for your personal risk tolerance. If you can’t sleep at night without a 12-month buffer, that’s okay too.
How To Build Your Emergency Fund
Building an emergency fund doesn’t happen overnight. However, with a little bit of planning and discipline, you can build your emergency fund quicker than you might think, by following these steps.
1. Clearly define your goal.
You want to have a clear target in mind. That means having a concrete dollar amount and a definite time horizon in which you want to reach it. This might be something like “I want to have $15,000 in 3 years.” Below is an example of what this can look like if you open a Safety Net goal in your Betterment account.
2. Prioritize your emergency fund.
Building your emergency fund should be a part of your overall financial plan. Usually, your emergency fund should be one of your highest priority goals (with the possible exceptions of maxing out your 401(k) employer match and paying down credit card debt).
3. Calculate your required savings.
Estimate how much you need to save per month to reach your target amount in your desired time horizon. This will depend on:
- Your target balance
- Your time horizon
- How much you already have saved
- The expected interest rate/growth rate of your account
You can calculate this yourself, or use Betterment’s goal forecaster to do this for you. Below is a screenshot of our goal forecaster to help you see how much you need to save per month to be on track for your emergency fund goal, and run what-if scenarios with different monthly savings, time horizons and target amounts.
4. Adjust your plan as necessary.
If you aren’t able to save that much, that’s okay. Nobody expects change to happen overnight.
It just means you may have to make some adjustments, like delaying your time horizon, diverting savings from other goals, adjusting your budget, or some combination of all of these. You can also use any windfalls you get, such as a tax refund or end-of-year bonus to reach your goals.
5. Make saving automatic.
Setting up a regular auto deposit can help you stick to your savings plan because it reduces the effort required to save your money in the first place.
Betterment allows you to choose the amount and frequency of your auto deposit, and even skip an upcoming auto deposit in case funds are tight.
Where should you keep your emergency fund?
Where you keep your emergency fund is very important. Below are 4 important points to consider when deciding where you will hold your emergency fund.
1. Separate from other goals.
It’s important to keep your emergency fund separate from your other financial goals you are saving for. This way, you don’t accidentally dip into it.
That means your emergency fund is not “part of your IRA” or mixed in with money for your kid’s college.
It also means it’s not held in your checking account where it can get mixed with your everyday spending. In fact, your checking account should usually only have about one month’s worth of expenses.
Below is an image of how Betterment keeps all of your money separate for each goal. This helps you stay organized.
2. Low Risk
Your emergency fund should be held in cash or what are typically considered low-risk investments such as a bond-heavy investment portfolio.
The image below shows the performance of the U.S. stock market (as represented by the S&P 500 index) from August 28th, 2018 through August 28th, 2019. This is a risky investment that is not well-suited for your emergency fund due its large swings up and down.This is not the type of behavior you would want in your emergency fund.
Data Source: Yahoo Finance. This chart represents the S&P 500 index from August 28, 2018 through August 28, 2019. This chart does is, nor should it be interpreted to be illustrative of Betterment’s portfolios or investment options. Investors cannot invest directly in an index. Past performance is no guarantee of future results.
3. Easily Accessible
Your emergency fund should be easily-accessible. Any account that takes longer than 4-5 business days is not recommended for your emergency fund. Ideally you should have no limits on how often you can make withdrawals and should be able to take out money without incurring fees or penalties.
4. Competitive Earnings
Not all low-risk investments are created equal. Many savings accounts don’t have competitive interest rates or they have high fees that can eat into whatever returns they might pay. Make sure your earnings are competitive and your fees are low.
If you are comfortable taking a little more risk with your emergency fund, you can put it into a bond-heavy investment portfolio at Betterment. This may give you higher returns compared to a savings account, but comes with added investment risk and volatility. This is why we recommend you add a buffer if you choose this option.
Wrapping it all up
Your emergency fund can be the foundation of your financial life. It can help you avoid debt and give you flexibility and peace of mind.
Usually your emergency fund should be around 3 months of your living expenses, but your personal situation may cause that to vary.
You should build your emergency fund as a high-priority piece of your overall financial plan.
Lastly, make sure it is kept separate from your other goals, is low-risk, easily-accessible, and has competitive earnings/low fees.