Nearly 70% of Americans have less than $1,000 in their savings accounts and over 45% have $0. This is a huge issue among our society and it leaves many people vulnerable to economic duress and hardship.
Most of us know that it is a good thing to have an emergency fund, but the question is, how much do we really need? Two months reserves? Three months? Six months? The answers vary across the board, but what is correct?
To answer this question, you have to take a look into your personal situation, your finances, and ultimately what you are comfortable with.
What is an emergency fund?
Before getting into anything else, we must first understand what an emergency fund is. Quite simply, it is money set aside to pay for absolute emergencies. When sudden expenses arise, it may feel like an emergency, but it might not be. Ask yourself:
- Is this expense unexpected?
- How necessary is this expense?
- It is urgent?
If the answer is yes to all of these questions, there is a good chance it is an actual emergency. Here are several examples of emergencies that warrant you to tap into your emergency fund:
- Job loss
- Pay cut
- Car accident
- Emergency medical expense
- Loss of reliable transportation
- Broken Furnace in the middle of summer
All of these situations are unexpected, necessary, and urgent. Now here are some examples of situations that aren’t emergencies:
- Christmas presents
- Back-to-school shopping
- Latest iPhone comes out
- Upgrade vehicles when yours work perfectly fine
- Huge sale at the store
When you look at the differences between the two lists, you can see these ones are not unexpected, aren’t necessary, and they aren’t urgent. When deciding to tap into your emergency fund, you have to ask yourself these three questions to determine if it’s truly an emergency or not.
How big should your emergency fund be?
The short answer is, most financial experts say you should have a conservative six months expenses set aside as an emergency fund. However, the right answer goes a little bit deeper than that.
Everyone has different living expenses, therefore, you need to determine what you are spending on necessities every single month. Track your spending for a couple of months until you start to see a pattern. From there you will be able to determine your essential expenses on a monthly basis. Add those up and multiple that number by three or six, depending on how conservative you are. Start small and build upon it often.
Why You Should Save
It’s fine and dandy to tell someone they should have an emergency fund, but what is the actual reason they should? Apart from covering your necessary living expenses, your emergency fund will do the following:
Prevent the need from using credit
Relying on credit to use as an emergency is not a good practice. This will only dig you further into financial hardship when disaster strikes. Sure, you will be able to pay for immediate cash needs right away with credit, but you’ll be paying that back with high interest after the fact. All credit does it transfer cash needed from the present into the future.
The only time when using credit should be considered is if you already blew through your emergency fund and you need a little more cash to satisfy an immediate expense.
Avoid the need to liquidate investments
Another thing you don’t want to do for sudden emergencies you have to pay for is liquidate your investments. These include stocks, mutual funds, ETFs, etc. By doing this, you will either sell your investments at a loss or you will sell them at a gain, creating a capital gain tax liability. Both scenarios you’ll want to avoid, especially during a financial emergency.
If you have a solid emergency fund in place, you will be able to avoid the need to sell your investments in an emergency.
Prevent the need from liquidating retirement accounts
You don’t want to rob Peter to pay Paul. Retirement accounts are the primary investment for peoples’ future and by liquidating it, to pay for an emergency now, you are robbing your future self. It may be tempting because you have many years until retirement, but you must avoid liquidating your retirement accounts at all cost.
By doing this, you will be subject to tax consequences and if you are under 59 ½, you may also have to pay a 10% withdrawal penalty. This may solve a short-term problem, but you are penalizing yourself massively in your future. Avoid this by having a well-funded emergency account.
These are only some of the worst things you can do when trying to pay for an unexpected emergency. With a little bit of thinking, you’ll start to realize there are many more. You can avoid all these situations by having a strong emergency fund in place and only using it on true emergencies.
Easy ways to start building your emergency fund
If you are having trouble saving up enough money to set aside for an emergency fund, here are some helpful tips to get you there:
- Calculate how much you need: As I talked about above, track your monthly spending and calculate the actual number you need every month for necessary expenses. Then multiply that by three or six months to get your emergency fund total.
- Set goals: With your emergency fund number calculated, set monthly goals to achieve that. This will force you to create better habits and make the task much easier to accomplish. If you are having trouble with this, you can automatically transfer a little bit of your paycheck, every pay period, into your savings account before you have a chance to spend it.
- Keep your change: If you use cash a lot to buy things, considering saving the smaller bills for your emergency fund. Or if you use debit and credit cards to pay for things, use an app like Acorns, that automatically rounds purchases up to the nearest dollar and transfers that to your Acorns account.
- Save your tax refund: It can be very tempting to spend your tax refund on a brand new TV, clothes, or whatever else you like. However, when that refund check comes in, have the discipline to go directly to the bank and deposit it right into your emergency fund account. Better yet, have the IRS deposit it directly into your emergency account, so you don’t have the temptation to spend it.
Everyone needs to save for the unexpected. An emergency fund is a way to live a less stressful life. It takes the pressure off, for unexpected emergencies, allowing you to sleep easier at night. Having those reserves can literally be the difference from weathering a financial emergency or going into financial ruin. Once you have an emergency fund saved up, be disciplined and only use it on actual emergencies. Remember, ask yourself: Is it expected? Is it an emergency? Is it urgent?