You’ve probably heard the golden rule of personal finance by now, “Pay Yourself First.” It is not the hottest finance tip but it is one that most adults still struggle with.
One in four Americans have no emergency savings according to MarketWatch in 2020, 27 percent of adults would need help with a $400 emergency expense, and 12 percent would not be able to cover the expense at all.
Building an emergency fund is one of the most important cornerstones for financial security. Below are some tips on how to build an emergency fund and why it is so important.
What is an Emergency Fund?
An emergency fund is the first building block to financial freedom. It is the money stashed away for a rainy day, the first place that you turn to when an unexpected expense interrupts your normal spending plans.
Generally, emergency funds are used for sudden car repairs, medical bills, a loss of income, home repairs, or a death in the family.
Why is it Important?
Your emergency fund is important because it is your first line of defense before using a credit card, a payday loan, or withdrawing from a retirement account. The absence of an emergency fund can be incredibly expensive.
Let’s say you had a $1,000 emergency and put the charge on a credit card that charged 18% interest. It would take 150 months of minimum payments to get rid of the debt including $1,396.70 of interest.
Pulling money from a retirement account like a 401(k) might be another option but that can be costly, too. Unless you qualify for a special exemption, you could pay nearly 20 percent on an early withdrawal.
This means to receive $1,000 you’d need to withdraw $1,250 to pay the fees. ($1,250 X .2 = $250 in fees).
But in this scenario, not having an emergency fund actually costs more than any fees or interest. Paying minimum payments to a credit card means less money to cover future emergencies. Withdrawing funds from your 401(k) means those dollars stop growing in the markets, which can seriously impact your future.
For example, $1,250 invested in a total stock market fund from November 2008 to April 2021 would be about $4,125. But since the money was taken out, that is $2,875 of growth that is missed.
Why those dates? That’s 150 months, the period of time you’d making minimum payments on the credit card to cover this emergency.
Having an emergency fund can help you avoid many of these hidden costs.
Should you Focus on Debt, Retirement, or Emergency Savings?
In finance, “it depends” is always an acceptable answer that can be applied in any situation, but not this one. Your emergency savings should always take precedence over debt and retirement.
This is because, without adequate emergency savings, it can cause your debt to swell beyond your control or undermine your long-term retirement goals because of early withdrawals.
You can and should be able to focus on more than one financial call at a time but if you do not have any emergency savings it is imperative to focus the majority of your efforts there before attempting to tackle other areas.
New emergency savings is like a seatbelt, you are protecting (and paying) yourself first.
Where Should you put your Emergency Savings?
Generally speaking, your emergency savings should be in a savings account.
This can be helpful for two reasons. For one, separating it from your checking account allows you to see exactly how much money you have to spend on a day-to-day basis and keeps a very clear border between what should be saved and what is okay to spend. Second, you may want to consider an online savings account or a credit union as these venues tend to offer the highest possible savings rates.
How Much Should you Have?
For years the general recommendation for how much one should have in emergency savings has been 3 to 6 months of living expenses.
I like to put a different twist on that metric by saying that your emergency savings goal should be a minimum of three to six months of your rent or mortgage. I prefer the rent/mortgage benchmark because it is much more concrete. Expenses can fluctuate each month, nor does the average person know exactly what they are spending every month. Everyone, however, knows the exact dollar amount for rent.
4 Steps to Building an Emergency Fund
Starting to build an emergency fund can feel impossible but there are some real steps you can take right now to get you closer to this goal.
Take a Look at Your Current Spending
Take a look at your current expenses to identify how much money you have available to save regularly. Depending on your financial situation you may consider cutting your spending in certain areas or looking for ways to increase your income.
For some inspiration, check out this podcast interview I did on how to turn your side hustle into a money-making business.
Determine How Much you Need
Using the money you identified in step one, determine how much you will need to reach your goal and when you will reach that goal. As mentioned earlier, an emergency fund should be between 3 to 6 months of your rent or mortgage.
Let’s say you’ve identified $300 per month in step one. If your rent is $1,500 per month then you would need between $4,500 and $9,000 for an emergency fund. This means that it would take 15 months to reach the minimum benchmark.
Unlike a New Year’s resolution, you want to ensure that your savings goal is met. The best way to do that is to set up an automatic transfer for the amount you identified in step one. You can make this a monthly transfer or bi-weekly transfer taken when you are paid.
This will help you reach your goals in your sleep.
Take Advantage of Windfalls
To help you reach your goals faster you may want to consider saving money from unexpected or irregular increases in your income. This could include a bonus or a tax refund.
Set the Right Expectations
Even though you have set up automatic transfers and you have set aside the amount of money you want to save each month, it does not mean that the plan will go through without a hitch.
On your savings journey, you may have an emergency or two as you are saving up. You could switch jobs or move to a new city that changes your income and living expenses. That is okay.
If you have an emergency that takes money out of your fund, be glad that it was there in the first place. That’s the plan working! The key is to continue progressing and be flexible should any stumbles occur.
Building an emergency fund will take patience and consistency. It isn’t always something that you can do overnight or even in a year. The most important thing is that you start the process now and continue to take steps forward every month.