Emergency Funds: Preparing for the Unexpected
Many people don’t understand the importance of establishing and maintaining an emergency fund until it’s too late. Are you financially prepared for a leaky roof? How about a broken-down car? If you lost your job, how long would you be able to support yourself and your family until you got a new one? The coronavirus crisis is a perfect example of how the unexpected can seemingly come out of nowhere, and why it's so important to get your personal finances in order.
An emergency fund is money that you’ve set aside to be used in these critical situations, be it to handle a minor home repair or to pay for something more serious, like medical bills. Despite the importance of having an emergency fund, however, only 39% of Americans have enough savings to cover a $1,000 emergency, according to a recent Bankrate report. Below are several steps to take to help you establish your own emergency fund.
Set a goal
How much you need to save depends on a variety of factors. Generally speaking, your emergency fund should cover three to six months of living expenses. Start with three months and aim to work your way up to six months. There are plenty of free online tools that can help you figure out how much you should have on hand. For example, NerdWallet’s emergency savings calculator offers instant insight into this planning consideration.
Keep your funds accessible
It’s important to pick a bank and a savings vehicle that will give you easy access to your emergency fund. Consider keeping a portion of your money in a regular savings account or money market, as it will provide some return, and you can withdraw it at any time without penalty. For longer-term funding, you might want to use a savings vehicle with higher interest, such as a certificate of deposit (CD). Using a short-term bond fund to get a bit more yield, can also be an alternative, although you do face some additional risks compared to cash or a CD.
Avoid savings pitfalls
There may be obstacles in building your emergency fund. Take a look at some of the most common pitfalls and ways to avoid them:
- Using your credit card as an emergency fund. Although credit cards are convenient, there are drawbacks. Using your credit card will likely resolve the immediate need, but when you think about interest on the debt and possible penalties, it may not be worth it in the long run.
- Cheating other accounts to fund your emergency stash. Withdrawing money allocated to other resources–particularly your retirement savings account–can do long-term damage to your financial picture. If you borrow from your retirement account and default on the loan, you could face serious tax implications and penalties. Think of it this way: taking cash out of your retirement account is like stealing from yourself in your golden years.
- Thinking that you can’t afford it. The most common excuse for not maintaining an emergency fund is that you don’t make enough money to save. Although your budget may be tight, you don’t need to put away hundreds or thousands of dollars all at once. Starting small works just as well. You might try brewing your morning coffee at home instead of buying it or bringing a bag lunch to work instead of going out. The savings may not be dramatic, but they will add up.
- Not touching your money after you’ve saved it. If you can easily see your savings account balance and transfer it to your checking account, you’ll be more likely to do so when you find something you want to spend it on. Open a savings account that is separate from your checking account — maybe even at a different bank.
Make it automatic
The influx of technology has never made savings easier. In just a few minutes on your computer or phone, you can open a high yield savings account or start saving via a mobile app. The key is to make deposits happen automatically, which takes the decision completely out of your hands. From scheduled transfers between accounts to convenient apps that save for you, automation can help you save money without thinking about it.
Establish your savings goal, figure out how much money you need to put away every month, and stick to the plan. Remember: it’s better to have an emergency fund and never use it than to face hard times with no means to support yourself and your family.
Presented by Carl Holubowich, CFP®
Certificates of deposit (CDs) typically offer a fixed rate of return if held to maturity, are generally insured by the FDIC or another government agency, and may impose a penalty for early withdrawal.
This material has been provided for general informational purposes only and does not constitute either tax or legal advice. Although we go to great lengths to make sure our information is accurate and useful, we recommend you consult a tax preparer, professional tax advisor, or lawyer.