Key takeaways:
- An emergency fund is money you save separately for emergency expenses.
- Although similar, a rainy day fund and an emergency fund differ in size and intended use.
- You can use emergency funds for medical or dental emergencies, home renovations, or major car repairs.
Life is unpredictable, which is why it’s essential to set money aside for unexpected expenses. Without a financial backup, sudden expenses like medical bills or car repairs could make it hard for you to reach your financial goals or stay out of debt.
However, saving money is easier said than done for many people. According to the Federal Reserve, in 2021, just two-thirds of Americans said they could pay an unexpected $400 expense using a credit card or other financing option.
Creating an emergency fund now can help you prepare for a better future. If you’re ready to get started, this guide can help you understand what an emergency fund is, how to start one, and how much you should save for unexpected expenses.
Emergency fund definition
An emergency fund is money you set aside for unexpected costs. These savings are meant for emergency expenses that are separate from your typical monthly and weekly expenses.
Additionally, these emergency savings can be used to help you if you lose income due to job loss or sickness.
Why do I need an emergency fund?
The reason to save for an emergency fund is simple: It’ll help you get by and stay out of debt if an emergency occurs. It may also give you peace of mind.
Without savings, an unexpected expense could set you back financially and lead to expensive debt. In a financial emergency, some people rely on credit cards, which can be harder to pay off. When credit card debt accumulates, it can have a negative impact on a person’s credit score and credit history.
If you already have debt, an emergency fund may be even more impactful because it can help prevent you from taking on more debt. Adding to your current debt may make your financial situation more stressful and costly.
When to use an emergency fund
Once you’ve saved up some money in your emergency fund, it can be tempting to use it for non-emergencies. Consider creating some guidelines to help you prioritize the use of your emergency fund. Write down the types of emergencies and unplanned expenses you’re comfortable using the funds for. That way, you have a guide to reference for the future.
When determining guidelines for your emergency fund, consider differences between a true emergency fund and a rainy day fund.
Rainy day fund vs. emergency fund
A rainy day fund is similar to an emergency fund, but they differ in size and intended uses.
- Rainy day funds are used for smaller expected and unexpected expenses.
- Emergency funds are used for big, unexpected events, or life changes.
Here are a few examples of how you can use the funds from both:
| Rainy day fund | Emergency fund |
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Pro tip: It’s smart to build a rainy day fund and a separate emergency fund. If you’re able to, given your current financial situation, adjust your budget and consider setting up monthly automatic payments for both.
How to start an emergency fund
Building an emergency fund isn’t as complicated as you may think.
- Calculate what you want to save: Having a savings goal can help you stay motivated to keep making contributions. Consider your income and expenses. Then, set a realistic goal to help you stay on track.
- Create a monthly goal: Once you have a goal in mind, break it down into smaller monthly goals. Having smaller monthly targets may make it easier to make consistent contributions.
- Automate payments: If your employer offers direct deposit, ask if they can divide your paycheck between your checking and savings accounts so you can automatically save a portion of each paycheck. That way, you can set it and forget it without missing a monthly contribution.
If your employer doesn’t offer direct deposit, you can still set up automatic transfers with your bank. Each time you get your paycheck, a portion of it will go to your fund.
- Save your tax refund. In the event you get a tax refund, you may consider saving some or all of it to your emergency fund. To make the process as seamless as possible, have your refund directly deposited into your emergency fund account.
- Review and adjust your monthly contributions: After you’ve made a few contributions, review how much you’re saving. If you’re having a hard time keeping up with the monthly contributions, adjust accordingly. If you’re on track or already reached your goal, try setting a new one.
Pro Tip: These tips can also help you build your emergency fund if you already have some money tucked away.
Where should I keep my emergency fund?
An emergency can occur at any time. So when setting up your emergency fund, make sure the funds are safe and easily accessible. Here are a few places where you can keep your emergency funds:
- Bank or credit union savings account: If you have a checking account with a financial institution, create a separate savings account dedicated to your emergency funds. Not only will they be safe, but you may be able to earn more money in interest. For example, if you opt for a high-yield savings account, you may be able to earn as you save.
- Prepaid card: With a prepaid card, you can load as much money onto it as you’d like. This means you can only spend the amount that’s loaded onto the card. If you lose your card, most providers will give you a new one so you don’t need to worry about losing your money.
- Cash: If the two first options aren’t right for you, consider keeping your emergency fund in cash at home or with a trustworthy loved one. Though a cash-based emergency fund won’t accrue interest. Additionally, it’s important to note that cash can easily be stolen, lost, or destroyed.
How much money should be in your emergency fund?
The amount you should have in your emergency fund depends on your income and expenses. A common rule of thumb is to save enough to cover three to six months of expenses. However, you may need to save more if you’re a business owner, work seasonally, or have a single-income family.
To get a basic idea of how much you need to save, think about unexpected expenses you’ve faced before and what they cost. Then, factor in your income and living expenses to help you set a goal.
If you’re struggling financially, or your paycheck is irregular, saving money may feel difficult. But saving just a little each week can provide some financial security.
Alternatives to an emergency fund
Using money from your emergency fund is one of the best ways to pay for unexpected expenses. But emergency funds take time to grow. If you need money quickly and your emergency fund won’t cover an unexpected expense, there are additional options you can use.
Some alternatives to an emergency fund include:
- Personal loan: If you have a decent credit history,, you may be able to qualify for a personal loan with favorable terms. If you do, the lender will give you a lump sum that you can use for whatever you need.
- Home equity loan or home equity line of Credit (HELOC): If you own a house and have equity in it, you can take out a home equity loan or a HELOC. A home equity loan is similar to a personal loan in that it has a fixed monthly payment, interest rate, and payment term. Unlike a personal loan, you need to use the equity in your home to back the loan. A HELOC is a financing option that’s secured by your home, which gives you a revolving line of credit to fund large expenses.
- Credit card: As a last resort, you can use a credit card. Although a credit card can help you if you’re short on time, the interest rates on credit cards are usually very high. If you’re unable to pay off the balance right away, you’ll start to accrue interest and add more debt to your plate.
The bottom line
Think of your emergency fund like an insurance policy. If you’re just beginning your emergency fund, start saving whatever you can as soon as possible.
After you’ve reached your goal, use the funds wisely. Keep in mind that each time you spend money, you’ll need to replace it to ensure your savings remain healthy. As your financial situation fluctuates, review your goals and adjust when needed.
Having an emergency fund, no matter what size, will give you a better shot at getting through a financial emergency without falling into expensive debt.
