You’ve started on the journey of working on your personal finances, but you have questions. Lots of personal finance books will reference the need to build an emergency fund as an essential part of creating a sound financial foundation. What is an emergency fund? Why do I need an emergency fund? How do I build an emergency fund? How do I start saving?
We’ve got the answers to help you continue on your way to build up your savings and that all important emergency fund.
No matter what your income level is or where you are in life, unexpected expenses can always come up, from a broken-down car to a surprise medical bill or a payment for something for your child. Having an emergency fund can give you peace of mind, knowing that you have a financial cushion to fall back on in case of an emergency.
What is an Emergency Fund?
An emergency fund is a savings account specifically set aside for unexpected expenses. It’s different from your regular savings account because it’s meant to be used only in case of an emergency. The amount of money you should have in your emergency fund varies based on your individual circumstances, but a good rule of thumb that’s been quoted in many finance books is to aim for three to six months’ worth of living expenses. This means that if you spend $3,000 per month on living expenses, as an example, you should aim to save at least $9,000 to $18,000 in your emergency fund.
Why is an Emergency Fund Important?
Building an emergency fund is crucial for financial security because unexpected expenses can quickly drain your savings and put you in debt.
For example, if you don’t have an emergency fund and your car breaks down, you may have to put the repair costs on a credit card, which can accumulate high interest charges over time. Similarly, if you lose your job and don’t have an emergency fund to fall back on, you may have to rely on credit cards or loans to cover your living expenses until you find a new job.
Having an emergency fund also helps you avoid tapping into long-term savings, or retirement accounts, which can have significant tax consequences and impact your long-term financial goals.
How to Build an Emergency Fund
Now that we understand the importance of having an emergency fund, let’s discuss some strategies for building one.
- Set a Savings Goal
The first step to building an emergency fund is setting a savings goal. As mentioned earlier, aim for three to six months’ worth of living expenses. Calculate your monthly living expenses, including rent or mortgage payments, utilities, food, transportation, and other essential expenses. Once you have your monthly expenses calculated, multiply that number by three to six to determine your savings goal.
If you’re just starting to build your emergency fund, don’t be intimidated by the amount you need to save. Set small goals and gradually work your way up. For example, you can start by aiming to save $1,000, then $2,000, and so on. Check out our money saving challenge printable here.
- Make a Budget
Creating a budget is an essential part of building an emergency fund. A budget helps you track your spending and identify areas where you can cut back to save money. Start by tracking your expenses for a month, then categorize them into essential and non-essential expenses. Essential expenses include things like rent, utilities, and food, while non-essential expenses include things like dining out, entertainment, and shopping.
Once you have your expenses categorised, look for areas where you can cut back. For example, you can reduce your grocery bill by meal planning and buying in bulk, or you can save on transportation costs by carpooling or using public transportation.
Download our free budget planner template here.
- Automate Your Savings
Automating your savings is an effective way to build your emergency fund without thinking about it. Set up a direct deposit from your pay check to your emergency fund savings account. This way, a portion of your pay check is automatically transferred to your emergency fund before you even have a chance to spend it.
You can also set up automatic transfers from your checking / transaction account to your emergency fund savings account on a weekly or monthly basis. This ensures that you’re consistently adding to your emergency fund, even if you forget to manually transfer money.
- Cut Expenses and Save Windfalls
In addition to automating your savings, you can also build your emergency fund by cutting expenses and saving windfalls. For example, if you receive a tax refund or bonus at work, consider putting a portion of it towards your emergency fund. You can also reduce your expenses by finding ways to save on monthly bills, such as negotiating lower rates on your cell phone or cable bills. Check out more tips in our article on 21 Easy Ways to Save Money.
- Look at a suitable savings account for you
When choosing a savings account for your emergency fund, you might consider a high-yield savings account. These accounts typically offer higher interest rates than traditional savings accounts, which can help your money grow faster. Look for accounts with no monthly maintenance fees and easy access to your funds in case of an emergency.
- Avoid Temptation
When building your emergency fund, it’s important to avoid temptation. Try to resist the urge to dip into your emergency fund for non-emergency expenses. One way to avoid temptation is to keep your emergency fund in a separate account from your regular savings or checking / transaction accounts. This way, you’re less likely to use the money for non-emergency expenses.
- Revisit and Reassess Regularly
Finally, it’s important to revisit and reassess your emergency fund regularly. As your expenses and income change, your savings goal may need to be adjusted. It’s also a good idea to periodically review your budget and look for ways to cut expenses and save more money.
In summary, building an emergency fund is a crucial part of creating a sound financial foundation. By setting a savings goal, creating a budget, automating your savings, cutting expenses and saving windfalls, considering the appropriate account to save your money in, avoiding temptation, and revisiting and reassessing regularly, you can build a financial cushion to fall back on in case of an emergency. Remember, building an emergency fund takes time and patience, but the peace of mind it provides is well worth the effort.