Why Should Creating an Emergency Fund Be a Top Priority?
An emergency fund can protect your finances when an unexpected expense arises and is wise to have as a high-priority savings goal.
Contributing Writer at Tally
February 2, 2022
While those things are important, the first thing you'll want to consider when saving money is an emergency fund. An emergency fund is a stockpile of cash set aside, typically in a savings account, to help pay unexpected expenses.
Here’s everything you need to know about emergency funds. To help you get started on your path toward achieving your savings goals, you’ll get answers to questions like, "What is an emergency fund?" and "Why should creating an emergency fund be a top priority?"
Overall, you’ll come to understand why an emergency fund is a crucial part of your personal finance plan.
What is an emergency fund?
As mentioned, an emergency fund is essentially cash set aside to help you in the case of dire circumstances. It's a bit different from a rainy day fund. A rainy day fund has around $1,000 in it to cover small, unexpected expenses, such as replacing a flat tire.
Thirty-six percent of Americans have indicated they would have difficulty covering a $400 expense. A rainy day fund ensures you have money in your bank account to cover these short-term, immediate expenses.
An emergency fund, on the other hand, is meant for use in more extreme circumstances. Your emergency savings account should have enough money in it to cover a few months' worth of expenses (more on this later). The fund can then help you cover unexpected expenses over a longer term or on a greater scale.
An emergency fund may cover:
Damage from natural disasters
Large home repairs
Auto accidents where you need major car repairs or a new vehicle
Establishing an emergency fund should be a key component of your financial planning.
So, why should creating an emergency fund be a top priority?
An emergency fund is important for a couple of reasons.
It can help you avoid credit card debt. If an unexpected occurrence arises and you don’t have cash on hand, you may need to take out a personal loan or put the expense on a credit card. These options come with interest, meaning there’s a cost to borrowing money. Credit cards, in particular, have high interest rates that compound. If you don't have the cash on hand to quickly pay off your statement balance, debt repayment could become difficult. By having an emergency fund, you’ll have cash on hand to cover the expenses and prevent taking on debt.
It can provide you with peace of mind. Sixty-four percent of Americans report that money is a source of significant stress in their life. Knowing you have extra money on hand as a safety net for unexpected situations can make for a more comfortable financial life.
How much should you have in your emergency fund?
The exact amount you should have in your emergency fund depends on your monthly expenses. Many financial advisors think it’s wise to have enough money in an emergency fund to cover three to six months of expenses.
To calculate this, you’ll need to know your living expenses. This includes expenses you absolutely need to cover, such as:
Your rent or mortgage
Health insurance, especially if you’re expecting your emergency fund to cover this cost if you lose your job
Car payments and insurance
Your cell phone or cable bill
Ultimately, what you deem as an essential expense is up to you. For instance, if you know you won’t cancel your Netflix account if you lose your job, you may want to put extra cash in your account to cover that.
The amount of cash you have stored in an emergency account is a bit arbitrary and largely based on your personal expenses. But, as a rule of thumb, consider setting a financial goal to have enough money in an emergency fund to ensure you can live comfortably and uninterrupted for up to six months, even if you don't have a source of income.
Where should you store your emergency fund?
It’s wise to store your emergency fund somewhere that meets the following criteria:
Safe from market fluctuations
Liquid enough to obtain it within a week
Not immediately accessible, so there’s no temptation to spend
There are a few things to note with this:
Protect your money from market fluctuations. In an ideal world, you won’t even need to use your emergency fund. But the odds of that happening are slim. When it comes time to use the fund, you want to make sure the amount you accounted for is, in fact, available.
If you put the funds in an investment account, it may gain or lose money as the market swings. This, in turn, could cause stress or reduce the amount you have available. Your emergency fund shouldn’t be something you're looking to make a lot of money on but rather a safety net you know is there when needed.
Make sure your funds are accessible. For instance, if you put the money in a certificate of deposit or a Roth IRA, you may not be able to access the funds without paying penalties. You want the funds to be liquid enough that they can be there in time to cover an unexpected bill.
Shield the funds a bit as well. For instance, if you keep them in a checking account, you may be more tempted to spend the cash. You may want to open a completely new account, or at least create a layer of separation to prevent accidental spending of the funds.
The one type of account that meets all of these requirements is a savings account. You could even look into a high-yield savings account, which might offer an even higher interest rate than a traditional account.
An emergency fund could be the first step on your savings journey
When it comes to saving money, an emergency fund should be one of your primary goals. By putting this safety net in place, you give yourself peace of mind by knowing you can cover large, unexpected expenses without having to take on high-interest debt.
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