How To Create An Emergency Fund And Why You Need One
If your car’s transmission blows and you need $1,000 to fix it, would you have enough savings to cover this expense in cash? If you’re like most U.S. adults, you don’t. And that’s unfortunate: Not having an emergency fund to cover unexpected expenses could cause you serious financial pain.
According to Bankrate's 2019 Money Pulse survey, only 40% of Americans would pay an unexpected $1,000 charge with money that they saved. More than one-third of respondents said they'd pay this expense with a credit card, a personal loan or by borrowing money from family members or friends.
That’s because these respondents have never built an adequate emergency fund. And if you’re one of the many U.S. consumers who don’t have such a fund? It’s time to start building one before an unexpected financial emergency forces you to run up your credit card debt or turn to a high interest rate personal loan.
What Is An Emergency Fund?
As the name suggests, an emergency fund is a stash of cash that you save to pay for unexpected emergencies, whether that be sudden car repairs, a burst water heater or a surprise medical expense.
If you have an emergency fund, you can pay for these surprises with cash. You won’t have to resort to putting big expenses on your credit card and facing the high interest rates that come with such a move. You won’t have to take out a costly personal loan, either, or beg friends or family members for financial assistance.
"Financial security is something everyone strives for, and a very important aspect of that security is being prepared for any emergencies that could occur," said Sacha Ferrandi, founder and principal of Los Angeles-based lender Source Capital Funding, and Dallas-based Texas Hard Money. "Whether it's an emergency medical bill or a loss in employment, having a fund set aside for unexpected hardships can save you a lot of worry."
How Much Money Should Be In My Emergency Fund?
Estimating how much to save in your emergency fund can be tricky. A good rule of thumb, though, is to save from 3 to 6 months' worth of daily living expenses in your emergency fund.
What counts as living expenses? You'd need to include enough money to cover your mortgage or rent, food, insurance, utilities, credit card payments, car payments and any other bill you pay each month and wouldn't drop to reduce your expenses during, say, a job loss.
If you calculate that your daily living expenses come out to $3,000 per month, you’d need $9,000 to cover three months of these expenses and $18,000 to cover six.
Timothy Wiedman, a retired associate professor of management and human resources with Doane University in Crete, Nebraska, said that while emergency funds can help people cover unexpected expenses, yours should hold enough dollars so that you can pay your monthly bills should you temporarily lose your job.
Wiedman said that 3 months of recurring expenses is an absolute minimum. But more, of course, is always better. It's impossible to predict how long it will take you to find a new job. Having a bigger financial cushion, then, is important, Wiedman said.
"For a great many folks, following the '3-month rule' may not provide enough protection," Wiedman said.
How To Start And Grow My Emergency Fund
That amount of money might sound overwhelming, and it’s true that most people can’t simply come up with $9,000. The key, though, is to start building an emergency fund with whatever you can spare each month.
First, draft a household budget that lists your monthly expenses and income. Then determine how much money you have left over and deposit a portion of these dollars into your emergency fund each month.
Don’t be discouraged if you can’t deposit as much as you’d like each month. Say you can only deposit $25 a week into your emergency fund. After a year, you’d have $1,300 saved. If you can boost that figure to $50 a week, you’d have $2,600 saved after a year.
You might be able to devote more money to your emergency fund. Maybe you can deposit $300 every month. After a year, you’d have $3,600.
The key is to start saving. Having some money in your emergency fund – even if it won’t cover 3 to 6 months of living expenses – is better than not having anything saved at all.
Where Should I Put My Emergency Fund Dollars?
The goal of an emergency fund isn’t to earn money. It’s to provide you with a safety net of cash that you can immediately access. Because of this, you should build your emergency fund in a risk-free savings or money market account.
If this account earns you, say, 2% interest, that’s even better. But the main goals with an emergency fund are safety and liquidity – not income.
Benefits Of Having An Emergency Fund
The biggest benefit of an emergency fund is that it helps you keep expensive debt at bay. Instead of relying on personal loans or credit cards – both of which come with high interest rates – you can cover unexpected expenses with money you’ve already saved.
Think of an emergency fund as a safety net protecting you from life’s sudden financial hurdles.
Dallen Haws, financial advisor at Haws Financial Planning in Sierra Vista, Arizona, said that if you don't have an emergency fund, the odds are high that you'll constantly struggle with debt and money problems.
"For the person who is not saving at all, it will be very difficult to get ahead financially," Haws said. "This person is a slave to money. If anything unexpected happens in their life, they will be forced to rely on loans – probably not at good rates – or family members. For most of us, it's not a matter of if these things will happen, but when."
What To Do After Making Your Emergency Fund
After you’ve built your emergency fund, what’s your next financial step? It’s time to boost your savings and build your nest egg for retirement.
If your company offers a 401(k), be sure to invest in it. You can also save money in IRAs to build your retirement nest egg.
It’s important, too, to work on building your credit. Your three-digit credit score is a key number. Lenders use it when deciding whether to approve you for home or mortgage loans. They also rely on your score when determining your interest rate on these loans.
You want your credit score to be as high as possible. Lenders consider a FICO® Score – one of the most commonly used scores – of 740 or higher to be a strong one. A FICO® Score under 620, though, is considered a weak one, and might cause lenders to reject your loan applications. You might also struggle to qualify for the best credit cards with a low credit score.
Fortunately, it’s not complicated to build a good credit score. Pay your bills on time each month and pay down your credit card debt. These two steps are the most important you can take when building a good credit score. And building an emergency fund, which makes it less likely that you’ll run up that credit card debt, is a good step to preventing your credit score from taking a dip.
For more tips on building and maintaining a strong credit score, check out Rocket HQSM.
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