The COVID-19 pandemic has been an epic wake-up call to the importance of saving money for emergencies. Households with no financial cushion face potentially disastrous consequences. Those who have emergency funds may be realizing it’s not enough.
An emergency fund is a critical component of any financial plan. But you need to know how much to save, where to stash it and when it’s OK to spend it.
A few guidelines can help you start building an emergency fund.
How much should you save?
Financial advisers have long recommended saving three to six months’ worth of necessary household expenses in an emergency fund. Necessary expenses are things like the mortgage or rent, transportation, food, utilities and medicine.
If your household enjoys two steady, secure incomes, three months of expenses might suffice. But if you are single, self-employed or working on commission, build your emergency savings account to six months of expenses – or more.
“It pays to err on the side of more emergency savings rather than less, so a cushion of six months’ expenses is what most households should aim for,” says Greg McBride, CFA, Bankrate chief financial analyst.
“Sole breadwinners or the self-employed may need nine or 12 months’ expenses to be comfortable. But this is a destination, and it will take time to get there, so the key is saving some of every paycheck to constantly be adding to your savings cushion.”
On the other hand, over-padding your emergency fund can cost you if you’re missing opportunities to invest for retirement or college. To start an emergency fund, you should devise a budget to get clear on how much money you have coming in and going out.
Use Bankrate’s home budget calculator to help you determine how much you can afford to save for emergencies.
Where should you keep emergency savings?
An emergency fund shouldn’t be kept in a place that’s too easy to access and that invites temptation – like in a shoebox in your closet – but it should be liquid and readily available.
“Your emergency fund needs to be in an account where you can get to it whenever it’s needed, where there is no risk of loss, and where you can earn a return that preserves at least some of your buying power,” McBride says. “An online savings account checks each of those boxes and is the best place for your emergency fund.”
Celeste Collins, executive director of OnTrack Financial Education & Counseling in Asheville, North Carolina, cautions against putting emergency funds in certain types of accounts.
“IRAs, stocks, mutual funds and even certificates of deposit are less liquid and typically have withdrawal penalties and/or investment risk from market fluctuations,” Collins says. “One should only use these types of accounts for emergency savings with careful planning and after allocating money into liquid accounts for urgent expenses.”
When should you spend emergency savings?
An emergency fund is for surprise events that need urgent attention, but which you can’t afford to pay for out of your daily budget – a medical emergency or a car or home repair that isn’t covered by a warranty or insurance, for example.
An emergency fund can also tide you over if you lose your job unexpectedly or have your hours cut.
“When determining whether it’s time to tap into your emergency savings, it is important to evaluate your complete financial situation, the duration of the emergency and the resources available,” Collins says. “Examples of emergency expenses include a dead car battery, burst pipe, a refrigerator not cooling or other urgent issues that compromise daily life.
“Other situations like job loss create emergency situations that aren’t short-term or one-time defined expenses, so more comprehensive planning is important to make emergency funds last as long as possible.”
For that type of planning, she recommends reviewing all monthly expenses to cut or reduce where possible in addition to looking at money-generating opportunities to help supplement the household budget, like selling things on consignment, bartering or offering personal services (like childcare).
Bottom line
Craig Willeke, senior educator with Florida-based nonprofit Money Management Educators, says emergency funds provide a softer landing during hard times.
“We’re all living in unexpected circumstances right now that no one could have predicted,” he says. “If you’re jogging along and trip and fall, you could twist your ankle or break a bone if you hit concrete. But if you land on a big cushion, it’s not going to hurt nearly as bad. An emergency fund acts like a cushion for things you just did not expect to come up.”
