The Definitive Guide: How to Start & Build an Emergency Fund

Creating a fully funded emergency fund should be the first step for people trying to get their finances in order.

These days the average American only has about $400 of emergency cash on hand. That’s hardly enough to pay for a month’s worth of food, let alone other basic needs such as housing and utilities.

If you don’t already have an emergency fund then follow this guide and take action on putting yourself in a better financial situation. If you’re living paycheck to paycheck or trying to aggressively pay down debt, then the last thing you want is another setback.

Emergency Fund Definition

An emergency fund is an account set-up to provide a financial buffer or savings cushion in case of job loss, or unexpected major expenses ( especially housing, vehicles, and medical expenses).

Emergency Fund vs. Sinking Fund

Emergency funds differ slightly from sinking funds. Both are set-up to help you manage your expenses, but a sinking fund is an account set-up for planned expenses that you are planning ahead for. Emergency funds are designated for things you can’t expect or have no way to plan for.

Read More: What is a sinking fund? The Key to Smart Budgeting

5 Reasons Why you Need an Emergency Fund / Emergency Cash

If you’re still unsure on whether or not you need an emergency fund, here are some reasons to always have emergency cash in your accounts.

1. Job loss: If you lose your job and primary source of income, an emergency fund can help you cover your expenses while you take time to look! The other major benefit here is that you won’t be forced to take the first job you find, but you may be able to take your time finding the right job.
2. Avoid new debt: An emergency fund can help you avoid taking on debt in case of emergencies.
3. Avoid defaulting on debt:If you already have debt such as a car loan or mortgage, then an emergency fund can help you avoid going into default.
4. Less stress: There’s no question that a fully funded emergency fund can be a huge peace of mind. If you know that you and your family have a few months of expenses saved up, then you’ll be way less stressed.
5. Major Expenses: Things like medical bills, vehicle maintenance, and home repairs tend to hit without warning. An emergency fund can help cover these things.

How much should I save for an emergency fund?

This is by far one of the most commonly asked questions. How much should I save in my emergency fund? There are a number of approaches for deciding on an emergency fund amount, but first you’ve gotta look some of the variables that play into this.

What are the factors that play into figuring out your emergency fund amount?

Job security & marketability

The more secure of a job you have, the less of an emergency fund you need to have. If you are confident in your ability to find new employment after losing your job, then you may want to increase your e-fund.

Risk factors

The more risk factors you have, the bigger of an emergency fund you should have. If you have chronic health issues, an older home, or a 10 year old car you probably want to have a nice emergency fund to cover your bases.

Dependencies

If you’re providing for a spouse, kids or aging parents then you’ll probably want to increase your emergency fund amount for two reasons. First, if you lose your primary income source, you’ll have more people to take care of in the meantime. Second, for every person you’re responsible for, you have that many more people who can get sick or get into an accident.

Income sources

If you have multiple income streams or have a spouse who is also working then you probably don’t need as big of an emergency fund. Side note!! One of my goals is to make enough non-employment income to over our monthly expenses.

Debt situation

If you’re weighed down with debt, then you probably want to have a decent amount of cash on hand to keep making payments each month no matter.

3 Approaches to Picking How Much to Save for an Emergency Fund

1. Living Expenses

A common approach to emergency funds is saving up a certain amount of months of living expenses. Most suggest 2-3 months and the most conservative people will recommend 6 months to a full year.

2. Arbitrary Amount

People who don’t use their monthly expenses as their basis typically pick a large, arbitrary amount and roll with that. I’ve seen people go with anywhere from $3,000 to $25,000 or more.

You want to be careful though because at some point a huge emergency fund starts to do more harm than good… more on that below.

3. The Dave Ramsey $1,000 Approach

The legendary Dave Ramsey suggests that people who are in debt should only keep $1,000 on hand and use every extra dollar to put towards their debt. This allows you to pay down debt as fast as possible and pay less in interest.

The disadvantage to this is that $1,000 is not enough to cover even two weeks of expenses for most people. Dave is right though–the more money you have working to pay down your debt, the better.

The Disadvantage of Emergency Funds: Opportunity Cost

It would make sense to think that the bigger of an emergency fund you have, the better, right?

Unfortunately, that’s not always the case. It is good to be protected and it’s great to have your bases covered in case you lose your job and need to get by for a few months without income. But at some point, there is an opportunity cost to having a big cash balance sitting still.

If you have any debt, then the interest rate you are paying is what you could effectively earn with your money.

If you’re debt free and trying to invest as much as possible, then every dollar not invested in the stock market would be missing out on an average return of 7%.

So for every dollar hanging out  in your emergency fund providing you peace of mind, there is an opportunity cost.

Your goal is to earn the best return that you can with the funds in your emergency fund.

Where Do you Keep/Put an Emergency Fund?

1. Basic Checking / Saving Account

The easiest place to store your emergency fund is in a savings account where you bank. It takes hardly any time to set up and the funds are easily accessible. But there is a huge disadvantage to this.

Most major banks pay almost nothing in interest.

The average interest rate in the US is .06%. No… That’s not 6%. That is .06 of 1%.

This means that for every $1,000 you are earning 60 cents. This doesn’t even keep up with inflation (3%). In simple terms, this means that any cash or cash accounts you have are earning a negative return every year.

That is awful.

The only benefit to keeping your emergency fund in your primary checking or saving account is that it is highly accessible.

2. Online Bank Account (Ally, etc)

The next best option for where to put your emergency fund is an online bank. These banks have lower operating costs because they don’t have a bunch of locations and ATMs to maintain and they are able to pay a much higher interest rate.

MUCH higher.

Online banks such as Ally (1.90%), Synchrony (1.85%), and Discover (1.8%) all pay more than 30x the national average in interest and are highly rated options. 

Compared to a standard big-bank savings account, these high yield online savings account are a great option.

The only thing you’ll be sacrificing is a tiny bit of accessibility.

3. Stock Investment Account

This third option is the riskiest, but it can be the smart play if you have a high income and a great monthly surplus in income over expenses. Keeping a large cash balance is a drag on your overall returns because it is not invested in the stock market.

Putting your money into an index fund gives it the best opportunity to keep on growing along with the market. 

The biggest risk is that your emergency fund could decrease in value, however you are also putting yourself into position to not lose out on the opportunity cost of that money sitting still.

If you do not have a good amount of surplus money coming in each month, then this is NOT the option for you.  

Big Fat Takeaway

If you haven’t started saving for an emergency fund, then start today! It’s time to start taking steps to protect yourself and your family’s future. Don’t wait until it’s too late.

If you don’t have the money right now to set-up an emergency fund, then set aside what you can and try to add to it each month!

If you still feel stuck trying to analyze the perfect strategy, then follow conventional wisdom: find yourself a high interest online bank and save up 2-3 months of living expenses and refuse to touch that money until you absolutely need it.