Updated May 2020: After a brief interview and mention by NerdWallet on the topic of using your emergency fund during The COVID-19 Pandemic, we have updated our blog post with some points that we made during the interview.
Maintaining an emergency fund (aka a rainy-day fund) is a fundamental component of a financially healthy life. This may seem “boring” or “basic” in comparison to the excitement of the stock market, but its importance cannot be overstated. An emergency fund protects you in the event of major, unexpected expenses or loss of income.
Where Should I Start?
Conventional advice suggests saving 3-6 months of expenses for a sufficient emergency fund. This can be a bit daunting, especially when starting at zero. Keep in mind that a small emergency fund is better than no emergency fund. Begin contributing small amounts over the next 6-12 months, and be patient as you work toward your goal of 3-6 months of expenses.
When advisors refer to saving 3-6 months of expenses for an emergency fund, they are usually referring to “non-discretionary” expenses. Non-discretionary expenses denote expenses that cannot be “cut out” of your lifestyle if necessary. These include: housing costs, utilities, groceries, and debt payments. To calculate your non-discretionary expenses, take a look at your budget. Imagine you lost your job today, and determine what changes you would make to each line of your budget. Decide where you could cut back on optional expenses. This new budget, with all of the cutbacks, is your non-discretionary expenses number.
There are many factors to take into consideration when determining if you need 3 months, 6 months, or even more in your emergency fund. If you and your spouse are both income earners, you might only need 3 months of expenses. On the other hand, single income families run a larger risk of losing all of their monthly income with a job loss. In this case, it would be advisable to save 6 months of expenses. If you are a business owner or have variable income, consider saving more than 6 months of expenses, as your income is less predictable. You may be able to safely have a smaller emergency fund if you own other investments or have other income sources to supplement you primary income.
Automate your Savings
If you are a 401(k) participant, you enjoy the benefit of automated savings. You don’t even have the chance to see the money before it is saved in a separate account. I would suggest setting up something similar for your emergency fund. Saving the leftovers of a budget at the end of the month is not effective. Saving must be proactive and set aside at the beginning of the month, just like bills and debt payments. Setting up automatic transfers from your checking account to your emergency fund the day after you get paid eliminates the temptation to see that money as extra spending money and helps you meet your saving goals.
Some employers will separate your paycheck at your request, depositing some in an emergency account and the rest in your checking account. If your employer does not offer this benefit, you can set it up yourself. First, direct deposit your entire paycheck into your emergency fund. Then, a day or two later, set up an automatic transfer from your emergency fund into your checking account for less than the whole paycheck. For example, if you want to save $100 from each $1500 paycheck, you would transfer $1400 into your checking account, leaving the $100 in your emergency fund.
Using Your Emergency Fund
There are two main mindsets when it comes to using emergency funds. Some people are tempted to use their emergency fund for anything they want. Others refuse to use their emergency fund even for things they really need. The first group will find it hard to grow their emergency fund to a healthy level because it is being used more frequently than it’s intended. The second group will incur more stress than necessary in their attempt to never touch their emergency fund.
In order to resist both of these pitfalls, I suggest creating a list of what you will use your emergency fund for. Write down the items that you approve and non-approve the use of your emergency fund for. For example, you might list, car maintenance, insurance deductibles, and Christmas gifts on the approved list and vacations, new clothes, and home décor on the non-approved list. Stick to this plan to save yourself from making those decisions “in the moment.” Once you use part of your emergency fund, you will want to put your monthly savings towards replenishing it in the coming months.
Setting Up A Sinking Fund
An emergency fund is used for an emergency - something unexpected that can end up using a lot of your cash. Your emergency fund shouldn't be used for expenses that you know will be coming every year (birthday and Christmas gifts, routine car maintenance, minor home maintenance, etc.). For these items, you should set up a sinking fund. This is a bank account that you set money aside in to cover your expected expenses. If you know that you will spend $1,200 a year on Christmas gifts, then send $100 per month into your sinking fund account. If you expect to buy new tires for your car every three years, then you would set aside an addition $30 per month into the account. Again, it is important to have a list of uses for that money, that way you feel comfortable accessing it later on.
Common Questions / Concerns
Where should my emergency fund be held?
First and foremost, an emergency fund should be safe and easy to access. It should not take a long time to move money from your emergency fund into your checking account. That being said, many traditional banks and credit unions have very low interest rates on savings accounts. The national average is 0.09%. Since your emergency fund will have a significant amount of money in it over a long period of time, try to find a bank that pays higher interest rates than the national average. There are several online banks that are offering closer to 1.65% at the moment (05/2020).
If I have to choose, should I pay down debt or have an emergency fund?
This is a difficult balance. On one hand, you can save a lot of money in interest by paying down debt sooner. On the other hand, having a good emergency fund can keep you from taking on more debt when you have unexpected expenses. It is important to keep a balance of both. If you expect to have $1,000 each month to either put towards an emergency fund or towards your debts, I would suggest putting $333 (1/3) in the emergency fund, and $667 (2/3) toward debt payments.
Can I invest my emergency fund?
It is wise to avoid subjecting your emergency fund to very much risk. Investments such as stocks and mutual funds might be easy to access, but you risk losing more of your investment (compared to cash / savings accounts). A bad few months in the stock market or poor investment choices could diminish your emergency fund by a few “months” which could be crucial if an emergency occurred.
Can I use my ROTH IRA as an emergency fund?
It’s true that you can pull some money out of your ROTH IRA without taxes or penalties, but that does not mean it is the best decision. First, your ROTH IRA should be invested, and it is not advisable to subject your emergency fund to risk. Second, the biggest benefits from a ROTH IRA come from an aggressive allocation over very long periods of time. Because of this, it is beneficial to keep the money in the ROTH IRA account for your retirement. However, if you do have a ROTH IRA, you may be able to reduce your emergency fund needs to only 3-4 months rather than a full 6 months.
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