Find out how building an emergency fund can give you peace of mind during a difficult time
What if, no matter what life throws at you, you wouldn’t have to worry about having enough money to cover it?
Life can be crazy and unpredictable, in ways we cannot even imagine (although in the last few months, we had a bit of a bitter taste of how quickly things can change).
But having a big enough cash cushion to fall onto will take away at least the financial stress that comes with uncertain situations.
I hate to be all doom and gloom, but in a matter of days, we could find out about an expensive emergency repair, lose our jobs or – let’s hope this never happens – get sick.
Can you imagine adding the stress of not having enough money to pay the bills to some of these unthinkable situations?
Honestly, the percentage of Americans with less than $1,000 in savings is shocking! According to new data from GoBankingRates, 69% of Americans have less than $1,000 saved in cash…and a staggering 45% have $0 in savings.
Do. Not. Be. One. Of. Them.
This is why building an emergency fund should be your priority, on top of everything else you are thinking of doing with your money right now.
And let’s be clear. Building an emergency fund needs to come before:
- Putting money in your pension
- Thinking of investing
- And even before paying down some of your debt
What is an emergency fund?
An emergency fund is your insurance policy against the unexpected. It’s a stash of cash that you keep in a safe place (i.e., not under your bed – more on that later), ready to be used when something out of your control happens.
- Your car breaking and needing an emergency repair.
- An unexpected medical bill.
- Losing your job.
- And, why not, even the next zombie apocalypse.
An emergency fund is there to protect you WHEN an emergency happens, not IF it happens. Because, no matter how prepared you are, unexpected things will happen in your life.
Emergency fund definition
An emergency fund is a readily available source of assets to help one navigate financial dilemmas such as the loss of a job, a debilitating illness, or a major repair to your home or car (Investopedia).
Why do you need an emergency fund?
No matter how prepared you are, emergencies happen to everyone…
An emergency fund will prevent you from going into debt when things in your life are tough.
You might think it’s crazy to set aside so much money, especially if you are on a low income or are already struggling. But it’s exactly when you don’t have much cash coming in that things can get difficult very quickly and unexpectedly.
How much money should you have in your emergency fund?
Ok, this is when things can get a bit wild.
There are different schools of thought about how much money you should have in your emergency fund.
My advice is to start small and build up your emergency fund from there.
You are a beginner if, whether you earn $10,000 or $100,000 a year, you struggle to get to the end of the month. You have to do everything in your power to save at least 3 months of your essential expenses (I will tell you how later).
Let’s be clear: 3 months it’s just the starting point, and it ain’t going to save you if the zombies are coming, but it will help you to cover your basic needs in case of a small emergency (like your car breaking down, or some minor unexpected medical bills).
You are getting the hang of your savings at this level, and you want to step up your game. Having 6 months of savings to cover your essential expenses will put you in a much better position.
Even temporarily losing your job shouldn’t give you too many sleepless nights: you will have plenty of time to figure things out without having to worry about paying your mortgage or rent and your bills.
This is a good level for most people who have a stable job and are not the sole or primary breadwinner in the house.
A whole year of essential expenses: this is the gold level. I admit it’s not easy to accumulate 12 months of essential expenses. And if you love investing it might feel like an unnecessary sum of cash sitting in a bank account losing value to inflation.
But having such a big cash cushion can get you out of most emergencies life will throw at you.
I would aim at this level if you want extra security, you are a single income family, or have an unstable job. But before you start to think about reaching this level, you should have all your debt paid off (except for your mortgage).
Go for 36 months of essential expenses set aside!
In our journey to financial freedom, I kept going back and forth about how much money we should put aside as an emergency fund. Considering we plan to take some time off work entirely and live out of our passive income investments, we had to be more conservative than most.
We decided to keep 3 years worth of living expenses in our savings account.
Yes, it’s a lot. Yes, we could generate a lot more by investing it in an index fund or buying more rental properties.
But you know what? Nothing makes me sleep better at night than knowing that we could beat most recessions by simply using our cash emergency fund, no matter what’s going on in the world.
How to build an emergency fund fast
Ok, you might need to go and make a cup of strong coffee, tea, or even pour a little glass of wine before you start working on building your emergency fund…because it’s going to take a while.
1. Calculate your essential expenses per month
Download your bank statements for your last 60 days and figure out exactly how much you spend on your essential expenses. Forget about cable, Netflix, your morning lattes, or eating out.
Here we are talking about bare-bones survival.
Spending time looking at the last 2 months of your essential living expenses will give you a good insight into what you will need to survive in an emergency (like losing your job).
You need to include things like:
- House expenses (monthly rent or mortgage, property taxes, home insurance, essential utilities)
- Transportation (car payment, insurance, gas, public transport)
- Health insurance, prescriptions, life insurance
- Essential debt repayment (any high-interest debt repayments that you need to keep paying)
To make things easier, you can download my emergency fund calculator. It will help you to figure out quickly how much you should set aside.
Emergency fund calculator
2. Look at your discretionary spending
Now that you have an idea of what you are spending on essentials, let’s go back to those pretty bank statements, and let’s look at how much you spend on average on everything else.
These are things like restaurants, work lunches, that lovely new pair of shoes you buy every month, going out drinking with friends…pretty much everything that you could cut out if you really had to.
Looking at what you actually spent on extras in the last couple of months is a very helpful reality check. You’ll be surprised at how much stuff we spend money on that we don’t actually need.
3. Cut back on discretionary spending
Now that you know how much you are spending on non-essential stuff, you can start thinking about what you can easily cut out from your daily life.
Maybe you could meal prep your lunch and bring it to the office 2-3 times a week but still eat out on a Friday? Or cancel your gym membership if you don’t go very often and just pay for classes?
The key here is consistency and not going too far. If you deprive yourself of everything you love, you won’t last long.
And remember: even looking at essential expenses can get you big savings. You could save money on cheaper home or car insurance. Or try to get a raise and save all the difference.
You could even look at creative ways to earn a bit of extra money on the side to beef up your emergency fund. Things like taking part in focus groups, selling clothes you don’t wear anymore, or renting your spare bedroom on Airbnb, can help you easily set aside hundreds of dollars a month with a little extra effort.
You can find more ideas on things you can easily save on in this post.
4. Save the difference
Once you have figured out how much you can set aside every month, just move the money into your emergency savings account as soon as your salary hits the bank.
Starting a budget is also going to help you to stay on top of your savings.
Don’t get discouraged by how long it’s going to take you to get there. And no matter how much you earn, you have no excuses: we can all learn how to save a bit of money every month.
Even if you can only save $15 a week at the end of the year you will have $780 in your emergency fund. That’s a big difference from having $0.
You can get there one little step at a time!
Benefits of having an emergency fund
1. It keeps your stress levels down
When you don’t have money set aside, every event that has a financial impact can turn into a drama.
Think about this:
You have one car, and you need it to drive to work. The transmission breaks, and you need to pay $780 today. Your check won’t come in for another 2 weeks.
What can you do? If you don’t have an emergency fund, you are going to struggle. And it’s not just about the money you need for the repair: you might lose hours at work, you might end up missing an important meeting. Or you might have to get a taxi to get to the office on time, creating even more debt.
Not only are you stressed out because of the situation. You will be doubling up on the stress because you don’t know how to pay for it.
You might have to put the bill on your credit card. Or even worse, you may have to use a payday loan, which has incredibly high-interest rates (we are talking hundreds of dollars). Plus, you will need to repay it by your next payday. Which means you still need to find enough money.
But with an emergency fund?
You are just annoyed by the inconvenience of having to bring the car in to repair.
There is a big difference!
2. It gives you financial stability
Having an emergency fund puts you in a position of strength because you can access cash in minutes.
And this useful in so many ways:
- You won’t have to take on costly loans to pay for emergencies.
- No need to sell your investments during a bear market.
- You won’t have to access your 401k if you lose your job.
3. It gives you peace of mind
I know money isn’t everything in life, But somehow, life gets a bit easier when you have some.
A while ago, a friend of mine was about to lose her job because the company she worked for was restructuring the team. She was so stressed out. Both she and her husband were working full time and had high-paying jobs but she confessed that if she lost her job they wouldn’t have been able to pay the mortgage after only a couple of months!
First of all, you should never put yourself in a situation where your housing expenses are so high that you couldn’t survive financially if one of you lost your job. Second, with a big enough emergency fund, my friend would have worried a lot less about losing her job.
You can see how having enough to cover your basic living expenses for 6 to 12 months can be a complete game-changer.
Where should you keep your emergency fund?
You need to remember that an emergency fund is not an investment.
It needs to be:
- Easily accessible
- And above all, safe
It’s not about getting the best return on your money, it needs to be liquid. Otherwise, it wouldn’t be an emergency fund.
But it’s also important that it’s not too easy to access, or you might end up spending part of it for, shall we say, silly reasons.
The best place to keep your emergency fund is in a high-interest savings account, where your money will stay safe and won’t be prone to swings in values but will still earn you a higher-than-average interest rate.
Also, make sure you can easily access your savings account at any time without penalties. Don’t be tempted to lock it away for 2-3 years to get a bit more interest.
Chasing a 0.5% extra in interest isn’t the point of your emergency fund!
The cost of having an emergency fund
Yes, having an emergency fund comes at a cost: every dollar you have sitting in a savings account isn’t invested. And if you have a big enough cash account, you could be losing big time.
And you are losing twice:
1. Opportunity cost: the average return, if you invest your money in the market is currently around 8% annually. Even at a conservative 6%, over the long run, you are going to lose out a lot.
Let’s compare the difference between having $100,000 sitting in a savings account at 2% for 10 years or invest it in the stock market at a very conservative 6% (remember, the actual average over the last 100 years is closer to 10%).
Money sitting in an emergency fund (savings account at 2% interest)
Money invested in Index Funds (6% return)
That’s a staggering $57,185.33 difference over only 10 years. Imagine how much you will lose out over 20-30 years (or don’t or you could start crying).
2. You are actually losing money: A good savings account these days can earn you between 0.50 to 1.50% interest, which doesn’t even cover inflation. This is why financially savvy people always invest their money. If you don’t invest, you lose buying power. And the longer you keep your cash in a bank account, the bigger is your loss.
So why am I even telling you to build an emergency fund and keep it in cash?
Because your emergency fund is your insurance! And you need insurance to go through life with ease.
No investment will give you the financial security of being able to access cash in an emergency.
When should you use your emergency fund?
An emergency fund is for emergencies! It’s not something you should use to buy a cashmere jumper on sale or to go on vacation.
These are things you can use your emergency fund for:
- Car repair
- Technology breakdown
- Emergency medical costs
- Emergency dentist bills
- Vet bills or pet costs
- Emergency home repair
- Boiler repair or replacement
- Unscheduled events and weddings
- Tax bills
- Legal bills
Suppose you want to set aside money for other things once you reached your emergency fund goal, fine. You can start separate savings account for things like vacations, clothing, and stuff you want to splurge on.
Ready to start building your emergency fund? Download this useful emergency fund calculator to find out how much you need to set aside.
With an emergency fund, you can focus on solving your problems when things go bad, without stressing too much about your finances because your back is covered.
Having a good emergency fund is the first step towards financial freedom. It will enable you to worry less about money and have more time to spend doing the things you love!