7 Steps to Build an Emergency Fund

An emergency fund is a cash reserve that you set aside for any unexpected emergencies that might come up. An emergency fund can be used for unforeseen circumstances such as medical bills, car repairs, job losses, and more.

The idea behind an emergency fund is to have money that is readily available when an emergency comes up so you don't have to tap into your investments, or take on debt to cover them. Most financial professionals recommend having 3 to 6 months of expenses saved, but we will discuss how much you should have in your emergency fund later on.

Yes, the vast majority of people do need emergency funds. Imagine that on a month to month basis, money was fairly tight for you, but every month you were able to cover all of your expenses. Lets say that one month your car broke down and it was going to be $1,500 to get it fixed.

If you didn't have an emergency fund, you might need to tap into your investments (if you have any), or worse, put it on a credit card that might send you into high interest debt. Further more, a survey by Bankrate found that 22% of US adults do not have any emergency savings, and 36% have more credit card debt than savings. Bankrate also found that 20% of people would pay for a $1,000 emergency with a credit card.

The point here is that you do need an emergency fund. An emergency fund is a key part of a good financial plan. Emergency funds allow you to do two things. First, it lowers your stress knowing that you are covered if an emergency arises. Second, it helps you avoid taking on high interest debt to cover your emergencies.

The best place to put your emergency fund would be in a high yield savings account. A high yield savings account typically earns a higher APY than a traditional savings account - up to 10 times more. You can check to see if your bank currently offers a high yield savings account.

If your bank does not offer one, there are tons of options that you can find at online banks. You might be wondering why a high yield savings account is the best place to put your emergency fund. Lets give you our reasoning below.

1) Safe

In general, high yield savings accounts are safe. Most of them are FDIC insured to protect your deposits. You don't want to put your emergency fund in an account or investment that is subject to lose significant value.

2) Accessible

Second, you want to make sure you can access your money when an emergency comes up. A high yield savings account allows you to tap into the funds when needed. Some financial experts would recommend a CD as a good place to put your emergency fund. However, an account like this does not allow you quick accessibility as you are locking up your funds for a set time.

3) High Interest

Thirdly, a high interest savings account does pay a higher APY than a standard savings account. The average savings account earns about 0.43%. By comparison, the average high yield savings account earns over 4%. The goal is to at least keep pace with the rate of inflation. However, sometimes that is wishful thinking during times of high inflation.

Step 1: Open a high yield savings account

You can either open a high yield savings account at your current bank if they offer one, or compare banks online. Once you have found a bank that you like, you can fill out an application to open the account.

This can typically be done online, or in person depending on your chosen bank. The application process can vary from provider to provider, but expect to have to provide your government ID, social security number, your contact information, address, and a way to fund the account.

We should also note that your emergency fund should be seperate from your other bank accounts. This is for a few reasons. First, you want to clearly see the exact amount you have in your emergency fund. Second, you don't want to accidentally spend money that was suppposed to go towards your emergency fund.

Step 2: Determine the total amount you want in your emergency fund

The second thing you need to do is determine the total amount you need in your emergency fund. In general, most financial experts recommend having 3 to 6 months worth of expenses in your emergency fund. What you want to do is write down all of your necessary expenses for each month.

Think of things like your rent or mortgage, utilities, groceries, insurance, car payment, phone bill and more. Write down how much each one costs per month and add up the total. Then take your monthly total, and multiply it by 3 or 6. This will give you a rough idea of what you need in your emergency fund.

Step 3: Break the total down into smaller goals

It will be easier to reach the total amount you need in your emergency fund if you break it down into smaller savings goals. For example, lets say that you are young and single so your neccessary expenses were $3,000 per month. Lets assume that you want 3 month worth of expenses in your emergency fund. This would total to $9,000.

Saving that amount can seem intimidating, but if you were able to save $750 per month, you would reach your goal for your emergency fund in a year. Saving $750 still probably sounds like a daunting task. Don't get to caught up on that as we will give you a better idea of what you really need in your emergency fund in the next section.

Step 4: Automate your savings

If you are currently receiving your paycheck via direct deposit you can see if your employeer can deposit a portion of your paycheck into your high yield savings account. Ask your employeer if they offer a split direct deposit and set it up if they do.

Although this is a good way to automate your savings, you will most likely have to reverse this change once you reach your savings goal for your emergency fund. A simpler way to automate your savings is to set up a recurring deposit from your account that receives your direct deposit to your high yield savings account.

Most banks will offer this option. You can typically do it online or through your banks mobile app. We recommend automating your savings goal each month so that you are not tempted to spend the money that is supposed to be in your emergency fund.

Step 5: Save unexpected income

If you receive unexpected income, it is best to save it. You might get a bonus at work, inheritance from a relative, and side hustle income. Most people immediately spend unexpected income. If you save it, it can help you reach your emergency fund goal quicker. Once you have reached your emergency fund goal, you can divert unexpected income to other areas.

Step 6: Stop contributing to your emergency fund once you reach your goal

It does not make since to keep contributing to your emergency fund once you have reached your total goal. Remember, your emergency fund is there to make sure you don't go backwards. It is not there to help propel you forward.

Once your emergency fund is filled up, you can take the monthly contributions and divert them some place else. Although it may be tempting to start spending that money, we recommend investing it since you were already saving that money. If you don't know how to invest, you can check out our beginners guide to investing.

Step 7: Only use your emergency fund for emergencies

Although this is obvious, we want to emphasize that your emergency fund should only be used for true emergencies. Many people do the work of building an emergency fund, but then spend the money on items that are not emergencies such as vacations and home improvement projects. Do not do this. You will be grateful you did not touch your emergency fund when a real emergency occurs.

Thus far, we have stuck with the general guideline given by most financial experts that you should have 3 to 6 months worth of expenses within your emergency fund. However, you might be asking yourself if you can get away with having less or more than that? Lets look at a few arguments on how much you really need.

1) Scenarios in which you only need 3 months of expenses

There are a couple of scenarios in which you can get away with only having 3 months worth of expenses in your emergency fund. First, you are an individual with stable income that does not have anyone depending on you. Second, you are a married couple that both have stable incomes. In both of these scenarios, you would most likely be able to recover from an emergency within three months.

2) Scenarios in which you should have 6 months of expenses

First, you are a single parent, or you are married with a single source of income. Second, you have a seasonal job, or a job that has fluctuating income such as commission based sales. In these scenarios, it is better for you to lean towards the 6 month mark.

3) Set up a starter emergency fund

At the end of the day, the amount that should be in your emergency fund is what you are comfortable with. Say that you are young and your expenses amount to about $3,000 per month. If you were to have 6 months of expenses in your emergency fund, that would amount to $18,000. Do you really need that much? Most likely not.

With that being said, it is still a good idea to at least have a starter emergency fund. Most financial experts recommend to have at least $500, but preferably $1,000. Once you hit the starter emergency fund mark, you can use the scenarios above to determine if you should be closer to the 3 or 6 month benchmark.

The short answer is that is depends. The easiest way to determine where your dollars should go first is by looking at the interest rate on your debt, and if you already have any sort of emergency savings.

Look at the interest rate on your debt

The first thing that you should look at is the interest rate on your debt. If it is something that has relatively low interest such as a car payment, it might make sense to prioritize saving. Keep in mind that you are going to pay down the car payment over time.

However, if your car breaks down and you don't have any emergency savings, you might have to go into more debt to cover the cost. If you have high interest debt (such as credit card debt), it might make more sense to pay down the debt quickly so you are not carrying high interest debt month after month.

Consider if you already have some emergency savings

If you already have some emergency savings, you can focus more on paying off debt if you want to. If you decide to go this route, focus on paying off high interest debt. If you have low interest debt, it would be better to continue to contribute to your emergency fund or invest those dollars.

If you don't have any sort of emergency savings, it would be better to focus on saving before paying off debt. Even if you already have debt, an emergency can cause you go into further debt if you don't have funds available to cover the emergency.

The short answer is that it is a good idea to have at least a starter emergency fund before you invest. Try to get your emergency fund to at leat $1,000. If you reach that amount and are comfortable with that, you can start investing.

Keep in mind that just because you started investing, does not mean you have to stop contributing to your emergency fund. Ideally, you want to do both at the same time. This way, you have funds to help build your future, and funds that will keep you from going backwards due to an emergency.

The bottom line is that everyone should have some sort of an emergency fund. Although saving 3 to 6 months of expenses is a good target, the exact amount you need can vary. Remember, your emergency fund is there to keep you from going backwards. Once you have reached your savings goal, you can start diverting your dollars else where.