What is an Emergency Fund?
As the name implies, emergency fund is the money set aside to take care of unforeseen expenses or future financial obligations. It is the kind of money kept for covering unexpected costs in everyday living.
These unexpected expenses can include;
- Unforeseen medical expenses.
- Home-appliance replacement.
- Car maintenance.
- Unemployment or loss of job
In cases like this, you may be forced to take unplanned loans or sell valuables asset just to take care of the financial situation. However, with an Emergency fund, you can avoid such situations and come out on top.
The need for an Emergency fund becomes even more prevalent as we grow older and take on more responsibilities in life. Emergency funds give peace of mind by providing backup when facing financial challenges.
Quick Facts About Emergency Funds
- Financial experts recommend saving 3-6 months of your income to build an emergency fund.
- It is important to save emergency fund in a savings account that is easily accessible, instant access to savings account is crucial in building emergency fund.
- Emergency funds can be saved for short term or long term depending on the financial goal.
- Emergency funds are used to pay unexpected expenses or safeguard against loss of income.
Classes Of Emergency Funds
Depending on the financial goal, emergency funds can be categorized as either a short term or long term fund.
1) Short-Term Emergency Fund
This type of money is kept in easily accessible savings account since the money is used to attend to emergency financial needs like paying medical bills.
Though the funds may receive little to no interest rate from bank but the most important thing is its quick accessibility when the need arise.
2) Long-Term Emergency Fund
This fund enables one to prepare for a major emergencies that require huge money or high cost.
For instance, during the period of disaster or job loss, saving for a reasonable long time can help to manage this financial crises. From another point of view, long term emergency funds can also be used to settle immediate financial need such as car repair.
Long term emergency fund brings more interest but its accessibility should be taken into consideration while saving up.
How To Build Emergency Fund
Managing your cash flow is the easiest way to get savings started. Depending on the kind of financial situation, to successfully build an emergency fund, the following are crucial steps to follow.
1) Set Emergency Fund Goal
- The general goal of any emergency fund is to meet up with a financial need.
- The goal will determine the amount of money to be allocated for savings from weekly or monthly income.
Having a monthly savings plan can help to build your emergency fund in the short term or long term without putting pressure to save a great amount of money at once. Financial experts recommend saving from 3-6 months living expenses when about to open an account for emergency funds. When doing this, the current income and total monthly expenses must be put into consideration.
From the start of the saving period, it is important to start small and continue at a pace that would not stress you to meet up with other pressing needs. Therefore, the amount required for monthly saving is a reflection of the goal of emergency fund. Putting aside 5% to 15% of your monthly salary would get one on the track of saving for emergencies.
Check out this article: Beginner Guide: What Is Budgeting and How Can You Set Up Your HouseHold Budget?
2) Create a Separate Savings Account
- Commitment and consistency are essential elements in building emergency fund.
Your emergency fund should be kept in a separate account to avoid spending it with other money. While choosing the saving account to use for savings, quick accessibility to money must be put into consideration, funds should be available for use when needed.
Money can be saved in low interest rate account to enable easy withdrawal. On the other hand, long term emergency fund can be tied for a long period to earn more interest, the duration depends largely on the goal of savings plan.
3) Enable Automatic Transfer
- Automate what you can. It helps you stay consistent and reduces the chance of you breaking your owns savings rule.
Setting an automatic or recurring transfer from checking account to savings is the best way to get along in building emergency fund.
It is expected for someone to purchase items without second thought, people with “impress buying” attitude do so more often when they receive money unexpectedly, receive bonuses at work or get tax refunds. Instead of spending this money, it can be instantly deducted from the income account directly into savings as contribution for emergency fund.
Also, a particular amount of money can be set for deduction monthly from the salary or checking account. This strategy becomes easy when one have online banking to enable transfer between accounts. Allocating portion of extra money into savings helps to cover for financial emergencies by refraining from excessive spending on unnecessary goods or items.
4) Cut Away From Unnecessary Expenses
Reducing expenses is akin to saving money. The less you spend the more you save. To build emergency fund, cost incurred on items not useful or needed should be removed from your budget.
Cutting away unnecessary spending requires discipline and commitment because enticing items may cause you to be tempted to buy what is not needed, its adherence will help to save more money for emergency fund.
To save more for emergency fund, the following tips may be helpful:
- Cancel subscriptions that you don’t use or need, such as cable TV.
- Take public transportation instead of driving everywhere to save cost.
- Take shopping at thrift stores or online consignment shops for clothing and other items.
Check out this article: 7 Harmful Money Habits Still Keeping You Poor
5) Sell Old or Unused Items
You get money from selling unused items. Raising money from sales of old appliances or stuffs can be a good start for build emergency fund.
Unused items can be sold via:
- Online sales: one of the easiest ways to sell your stuff online is through eBay, Facebook Marketplace, or Craigslist.
- Garage Sales: Another great way for people to turn their things into cash is by holding garage sales. By advertising through online media, or sharing flier will inform neighbors, friends, and family about available stuff for sales at your place. Most people would like to come since they know the price is considerably cheap.
6) Increase Your Income Potential
- Having a part time work is another way to increase income – a means to save more.
- Part of extra income can be allocated for growing emergency fund.
Some jobs requires less commitment or stress and provide good additional earnings. These flexible jobs may include, delivering pizza, mowing the lawns etc.
7) Regularly Monitor Your Progress
Monitoring the progress of savings for emergency fund is important.
Checking the account balance to know how much and when to move money to the emergency fund should be carried out either weekly or monthly at convenience. It does good to watch the progress of savings and make adjustment if need be. It is encouraging to see the progress of building emergency fund near achieving.
Where To Keep Emergency Fund
Emergency funds play a different role from your investment funds, so your goal should not be to make substantial gains from it. Instead you should focus on secure investments that might help you beat inflation. You will also want to focus on investments that provides quick accessibility to your funds in case you need it for an emergency.
Here are some of the best options for where to keep an emergency fund.
1. High-Yield Savings Account
High-yield savings account accounts are one of the most secured ways to earn interest on your money while still having quick access to it in times of need.
You can earn as high as 2.00% annual percentage yield (APY) from some of the industry leaders.
To open a High-yield savings account, you will need to sign-up to an online bank. A number of online banks offer various rates of high-yield savings accounts, so it is important you keep an eye on the rate, the fees, and other perks you can get when you sign-up.
It is also very important you keep a close watch on the rules concerning withdrawals. This way you can always avoid additional fees.
2. Money Market Account
The Money market account is very similar in function and operation to a typical high-yield savings accounts. However, Money Accounts are offered by local banks while High-yield savings account are mostly offered by online banks.
Local banks already have the infrastructure to make your banking easier. This affects the Money market account and provides multiple features that allows depositing, withdrawing, and monitoring your money market account balance very easy.
This includes Money market accounts sometimes coming with; a debit card and check-writing capabilities, making them more convenient.
The only negative is that money market accounts generally require a larger minimum deposit. And the amount of interest you can earn might be tiered based on your account balance.
Check out this article: Money Market Account vs High-Yield Savings Account. Which is best?
3. Certificate of Deposit
Certificates of deposit (CDs) are another popular option to a lot of emergency fund savers. However, unlike the Money market and High-yield saving account, CDs have a required period for you to keep your money locked away in a specific account.
In exchange for this, you will receive a guaranteed rate of return which you can withdraw along with your initial funds once the CDs term expires.
A CD’s “term” can be as short as a month or as long as five or more years and they typically offer higher interest rates than the two previous investment option. The longer the CDs term, the higher the APY you can gain.
The only issue with this is the lock up risk. If you face an emergency before your CD has fully matured, you will still be able to withdraw your money from a CD, However, you will need to pay an early withdrawal penalty.
The fee could be a flat fee or a percentage of the interest earned on your CD up to that moment. It will all depend on the Bank you open the account with. Fees like these will affect your emergency fund goals but there are multiple ways you can learn to fix this.
Check out this article: Certificate of Deposit (CDs): what is it? How Can I Get Started? What is Laddered CDs?
Other Popular Ways To Keep Your Emergency Funds
Savings accounts are considered the safest place to keep your emergency fund so as to avoid spending it along with other money.
Emergency funds can be saved through the following means:
- Bank or credit union account— Keeping money in savings account for use when need arise.
- Prepaid card —A prepaid card can be loaded with money as a financial backup in form of emergency fund.
- Cash —this option allows keeping money at hand for emergencies, but care must be taken to ensure the safety of the money.
Conclusion
Life is unpredictable but having an Emergency fund to safeguard against financial crises could be the best decision you make. It helps you prepare for any unexpected expenses that may create a financial shock and reduces the likelihood of borrowing money at high interest rate.
Deductions from checking accounts, cutting away from unnecessary spending, selling out of unused items, automatic transfer into savings account, monitoring the savings progress are steps to follow in building your emergency fund.
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