How to Create an Emergency Fund (and Why You Need One)
Posted on July 22, 2022 in Debt
Let’s face it: We will all be hit with an unexpected expense at some point in our lives, and you will be kicking yourself for not learning how to create an emergency fund sooner. Maybe you take your car in for emissions inspection to discover a problem that will costs a couple of grand to fix. Maybe that tree you’ve been meaning to trim back fell in a storm, landing on your fence and roof – and you have a $1,000 deductible. Or maybe you fell while playing volleyball at the park and your kind-hearted teammates called an ambulance, which came with a hefty bill your insurance won’t cover.
Scenarios like these don’t happen often, but when they do, having some dough tucked away can make life a whole lot easier. With an emergency fund in place, you won’t have to scramble to find funds, possibly maxing out credit cards or having to apply for a quickie loan.
While you may have a savings account set up to put money aside for a future home, a big vacation or college funds, creating an emergency fund is meant to help on rainy days.
And while financial experts suggest you should have three to six months’ worth of living expenses set aside in an emergency fund – in the event you should lose your job – having just a few thousands dollars stashed away is better than being entirely unprepared.
How to Create an Emergency Fund
1. Create a Budget
Before you can determine how much you can afford to set aside each month into a savings plan, you first need to understand how much money you have coming in and going out. A budget is always the first step in any financial journey and although the word may strike fear, there are a variety of ways to review your finances and create a budget.
Various apps and financial institutions, perhaps even your current bank, offer ways to access your spending habits and your income. Using apps like Mint or Personal Capital can show you were your money is going and help find areas where you can trim expenses to start redirecting some of your money to build an emergency fund.
2. Set a Goal
Once you know how to plan a strategic monthly budget and have an understanding of how much you can fiscally handle, set a target dollar amount and date.
While it may be tempting to go big and fund an entire emergency fund within a year, make small steps you can easily accomplish and allow yourself to build momentum. To save $1,000 in six months, for example, requires a commitment of $167 per month.
After seeing ways to cut expenses – cutting a daily tall caramel macchiato at Starbucks and pausing your Peleton subscription for six months – you may discover that savings goal is easily attainable.
When you hit your small goal, create a new one for the next six months, increasing your goal, perhaps doubling it. By the end of a year, you could have $3,000 set aside in your newly created emergency fund.
3. Select a Savings Vehicle
As an emergency fund, put your money into an account that is not easily accessible. This savings account, for instance, shouldn’t be connected to your checking account to be used to cover an overdraft or for an easy transfer between accounts. Instead, set up an emergency fund in an account that would require an emergency to access, and one with higher interest rates than a standard savings account.
High-yield savings accounts, certificates of deposit (CDs) and money market accounts are good vehicles for emergency funds. CDs can be set up in terms from one month to one year, tying up your money in an account until the term ends and accruing higher interest as it does so. As a term ends, you can withdrawal funds or roll into a new term.
Money market accounts are similar to an interest-bearing checking account, but it doesn’t mean you can easily access your funds. These accounts limits the number of withdrawals while providing higher interest, so you’ll be less likely to remove funds unless you really need them.
The easiest access to your funds will come through a savings account, but selecting an online bank separate from your bank will limit access while providing higher interest than a traditional bank savings account. For instance, Bank of America savings account provide savings at just 0.01% annual percentage yield (APY) while online Chime’s high-yield savings provides 0.50% APY.
4. Save Automatically
Money you don’t see is harder to spend and many banks and financial institutions allow direct deposit from your employer.
Instead of receiving funds in your paycheck, having them automatically taken from your paycheck and put into your emergency fund. You’ll are likely to notice the “pay cut” than if you are moving the funds between accounts yourself.
And some banks offer incentives for setting up a new savings account using a direct deposit or regular contributions. For example, Alliant Credit Union will give you $100 if you deposit $100 each month into a savings account.
5. Save Windfalls
Whether its tax season and you discover you’ve earned a refund, it’s your birthday and your parents sent you a fat check, or your company had a great year and is giving you a bonus, when a lump sum lands in your lap, take it straight to the bank.
It may be more exciting to spend it on a weekend getaway or a new flat-screen TV, but socking away money you weren’t expecting is the fastest way to funding your emergency account. (Keep a fraction if you really want a taste; just don’t spend it all).
6. Make More Money
Today’s gig economy is so hot it is making it easier than ever to have a side hustle. Pick up a part-time job, download money-making apps for quick cash, or work after hours doing gig work and put the additional money you make entirely in your savings, using your day job earnings for living expenses. By finding ways to make more money, you won’t feel the squeeze in your living expenses and, once you reach your goal, you can give up the extra work – or keep it up and use the funds in an investment account to continue your financially independent growth.
Mistakes Not to Make When Creating an Emergency Fund
There are three mistakes people make when working to create an emergency fund, often resulting in the lack of an emergency fund. Here are the three don’ts of creating an emergency fund:
1. Don’t Dip into an Emergency Fund
When you’ve never had an emergency fund, it’s easy to see a big dollar amount in your portfolio and have a moment of weakness. You can replace it later, right? But remember why you have created this account. This is your own personal insurance fund and borrowing from yourself will hurt only you. Don’t dip into your emergency savings unless you have an emergency expense and no other option.
2. Don’t Forget to Replenish
When an emergency has arisen and you’ve had to pay an expense using the funds you allocated for such an expense (well done!), it’s time to rebuild it. Return funds as quickly as you can to emergency account, starting small again, if you need to start from scratch. There will always be another emergency; be ready for it.
3. Don’t Stop
Once you have met your goals, don’t stop contributing to your emergency fund. If you have been able to put aside a chuck of change each pay day or month, aim to get your emergency fund to that highly recommended six-month’s worth of living expenses. And when you hit that goal, keeping going. If you are financially secure enough to have six months’ income put aside, take the extra money you’ve been saving and begin investing for higher returns and, if you haven’t already done so, pay off debt.
Create an Emergency Fund Today!
You are reaching a pinnacle of financial security so don’t quit. Next, it’s time to grow your net worth!
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