Emergency Funds: Strategies to Save for Financial Disasters

An emergency fund can help you respond to unexpected events and protect your ability to reach your overall financial goals. It’s smart to cover emergency savings before directing money into investments or unnecessary spending.

What Is an Emergency Fund?

An emergency fund is money that you set aside in a bank account for the unexpected – a job loss, a home or auto repair, or a medical issue. Every financial plan should include a rainy day fund. It can help prevent financial hurdles from becoming financial disasters.

There are different rules for emergency funds.

Emergency Funds Must Be Available Now

Instant access to your money is more important than a high rate of return. For this reason, emergency savings does not mean assets that you have to sell first to convert to cash.

Emergency Funds Must Be Readily Accessible

Avoid accounts that require you to request a check or wire transfer during business hours.

Emergency Funds Must Be Safe

Money in reserve for emergencies should be held in accounts that cannot lose value. They are not an investment.

Emergency Funds Should Not Be Subject to Penalty

Don’t put your emergency savings in any account that penalizes you for withdrawing. For example, a CD with an early withdrawal penalty or a retirement account tax penalty.

The amount you should have in an emergency fund depends on many factors. What’s most important is to start a fund now if you don’t have one.

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Why You Need an Emergency Fund

You need an emergency fund because you’re not financially bulletproof.

There are two kinds of emergencies for which to plan: unexpected expenses and interruptions to your income.

Expenses

Extraordinary costs include emergency automotive repairs, equipment repair/replacement for your business, appliance repair/replacement for your home, and medical visits.

Income

An income interruption (like a job loss, reduction in hours, or a business slowdown) means you need money to cover your ongoing, regular living expenses until the situation resolves.

There’s a good chance that you’ve already experienced one or more monetary emergencies, so no one needs to tell you what’s possible. But not being able to meet bills that weren’t planned can cascade into larger financial problems that could set you back financially for a long time.

When Americans are short of cash and need help paying bills, they tend to reach for their credit cards. This may be a convenience, but it can be an expensive way of dealing with a financial emergency.

Having a ready reserve of money can help you deal with the unexpected without taking on credit card debt with high interest rates added on. Here are some examples of when you might need emergency funds:

Pay for Car Repairs

From a flat tire to a blown transmission, the cost of car repairs can easily be a shock to the average person’s budget.

Make Medical Bill Payments

Even with health insurance, co-pays and other payments within your deductible can get quite pricey, and some treatments are not covered at all.

Replace Necessary Technology or Equipment

You need to be disciplined about what you consider essential — for example, concert tickets or a video game console should not really make the cut — but items like your smartphone or laptop might be necessary for doing your job or looking for work. Thus, if they go down, you need to be able to replace them promptly.

Use as Income After a Job Loss

Even if your expenses are comfortably within your budget, losing your job can make it impossible to make ends meet without a cash reserve to help you get by until you are back to work.

How Much Do You Need in an Emergency Fund?

To cover loss of income, the rule of thumb experts use is three to six months of expenses. Whether your needs are closer to three or six months depends on how risky your financial situation is. These questions can help you gauge how much money to save:

• How much ongoing debt do you have?
• Are there two breadwinners in your household or just one?
• How stable is your job, your company, and your industry?
• Do you earn a salary or commission – or are you self-employed?
• How well-insured is your health? And your home, belongings, and life?

A two-earner household with little debt, lots of job security, regular salaries, and good benefits probably requires much less emergency funding than one with a self-employed single earner in an insecure industry who is carrying the bare minimum of insurance coverage.

Average Costs of Common Emergencies

In an American Express survey, nearly half of respondents claimed that they’d experienced a need for extra money in the past year. Car trouble, health issues, and home repairs were the most common. Here’s what an average mishap can cost you:

• Average ER visit out of pocket: $2,909
• Car repairs average: $500-$600
• Car accident repair costs: $1,500–$4,000
• Average costs for repair of water damage: $3,455
• Electrical repair costs average $318
• Roof repair cost: $400-$2,000
• Septic system repair average: $1,795

Other Ways to Meet Common Emergencies

These amounts can be scary. Fortunately, you can minimize the damage to your wallet with a little planning.

• Keep your credit card balance and other debt low.
• Purchasing a home warranty for a few hundred dollars a year protects you from catastrophic home repair costs.
• Health insurance, home insurance, renter’s insurance, and other coverage protect you from major costs. You can even buy health insurance for your pets.
• Many electronics come with extended or expanded warranties if you’re willing to pay for them. Most personal finance experts don’t recommend these warranties, but if you need your electronics for work and have no savings, they might be worth considering.

Finally, preventive maintenance for your home, health, and automobile can lower the odds of an emergency expense.

How to Build an Emergency Fund

If you don’t have an emergency fund, you need to build one into your budget immediately. Begin with a baby step – a $400 savings goal. Just $400 in the bank can head off many common financial emergencies.

Tips for Starting a Rainy Day Fund

1. Find one regular cost you’re willing to forego until your emergency fund is topped up. Divert what you normally spend to your emergency account until you meet your goal.
2. Front-load your emergency fund by selling unwanted things. This can provide a satisfying chunk of money and the motivation to keep saving extra money.
3. Open up a line of credit, but don’t touch it. Reserve this for emergencies only. Having access to funds can reduce the amount of cash you need in an emergency fund.
4. Put at least some of any windfall you receive, like a tax refund, into your emergency fund.
5. Have your employer split your paycheck between two accounts: your checking and an emergency savings account.

Once you have a fully funded emergency account, review it periodically to make sure it’s still right for you. You may be able to reduce it, for example, if you sell your home and move into a cheaper rental. On the other hand, you may need a larger fund if you develop a medical condition or start a business.

Best Accounts for Emergency Funds

While there are many ways to invest money, from real estate to retirement accounts to stocks and mutual funds, the only two requirements for emergency funds are easy access and protected value. Emergency savings is not an investment. It’s insurance.

Your main goal, then, is to find an account that’s simple to administer and pays the best savings account rate within its category. You’ll also want to choose an account with low or no costs. Unless your emergency fund is enormous, which would be very unusual, low bank fees are probably more important than getting the best interest rate.

The three main account types that lend themselves to emergency funding are the following.

Savings Accounts and Money Market Accounts

These are safe and immediately liquid, and although savings and money market rates are usually the lowest bank rates, you can do a little better if you shop across several banks. (If you don’t want to shop for rates in person, you can compare savings account rates and money market account rates from hundreds of banks on MoneyRates.)

Checking Accounts

When savings and money market rates are low, consider keeping a portion of your emergency fund in checking so your balance can qualify you for a fee waiver.

Certificates of Deposit

Longer-term CD rates are typically higher than savings and money market rates, and even though there is a penalty for early withdrawal, assuming you don’t have an emergency every year, you could come out ahead keeping at least a portion of your emergency fund in a CD.

Finally, remember to take the name “emergency fund” literally. Don’t dip into it every time you feel like a vacation or a shopping spree. Instead, enjoy the comfort of having this security blanket at the ready if you really need it.

How to Set Up Your Emergency Savings Accounts

Think about how emergencies happen and how you would likely respond to one. A lot of unexpected events don’t require a large amount of cash immediately, so having different types of accounts that let you respond in sequence as expenses are incurred is a good approach.

Your First $1,000

No-fee or low-fee savings accounts are fine for smaller emergency funds. Your first $1,000 should go into a simple savings account. Savings accounts are easy to access but not as tempting to spend as money in checking accounts. You should be able to transfer your emergency funds online into your checking account in a hurry if needed.

Larger Emergency Funds

Once you’ve saved enough to cover a small emergency, you’ll want to amass your rainy day fund in case your income stops for a few weeks or months.

That savings could go into a money market account. The best money market rates can sometimes be higher than those of savings accounts, but it’s important to shop and verify that the account is FDIC-insured. With higher balances, you should have no fees. Be careful when choosing a money market account because mutual fund money market accounts can lose value and they don’t have FDIC protection.

Long-Term Planning

If your financial plan includes keeping amounts ready in the event of a disruption to your income, a certificate of deposit could help you earn more interest.

But what about the penalty for early withdrawal? Aren’t you supposed to avoid accounts that penalize you or can fall in value?

Yes, you are.

But once you have a $1,000 emergency savings account and perhaps one or two months of savings in a money market account, you’ve bought yourself some time. That time can be used to increase your rate of return. A CD ladder can help in this situation. By “laddering” your CDs, you can make it so you’ll always have one maturing within a few weeks.

How do CD ladders work?

You purchase several CDs with varying maturities. For instance, you could spread $5,000 out between a 3-month CD ($1,000), a 6-month CD ($2,000) and a 12-month CD ($2,000).

High-Interest Checking Accounts

One additional vehicle for those who put aside larger amounts is the high-interest checking account. High-interest checking accounts often come with premium features like unlimited checks, a debit card, online account management, rewards points, and free overdraft protection. With a high enough balance, you shouldn’t have to pay maintenance fees.

You usually have to meet a number of conditions to earn the higher rate. That might mean signing up for direct deposit and electronic statements. You might have to conduct at least ten monthly transactions. You might need at least one bill pay or transfer from the account per statement period.

You probably won’t find the best emergency savings accounts for every category at the same institution. As you graduate from savings accounts to money market accounts or money market funds to CDs and high-interest checking accounts, compare offers from a variety of banks. The more interest you earn and the fewer fees you pay, the faster you can pull together a good portfolio of emergency savings products.

You may do best by sticking with the money market account, but shopping for a better rate. Or, if you rarely ever dip into your emergency fund, you could look for a longer-term CD with a low early-withdrawal penalty and raise your yield that way.