What is an emergency fund?
Your emergency fund is the amount of cash you have in a safe place to cover an unexpected expense (such as a car repair) or event (such as a layoff). You should always aim to keep the money in this account untouched unless an unforeseen event occurs.
Why is it important to have an emergency fund?
This is the money you want to be there for you before having to withdraw from other sources. Having a sufficient emergency fund can prevent you from:
- Being forced to sell your investments in a down market
- Running up credit cards balances
- Being forced to withdraw from a tax inefficient source
- Experiencing undue stress when you’re not sure how you will pay your bills
How should I prioritize saving for my emergency fund?
Not everyone should have a fully funded emergency fund right now, but you should be working towards one. The reason is you may have better uses for your cash until you have some fundamentals of your finances in place. I’d prioritize your saving in the following order:
- Contribute to your employer sponsored retirement plan (such as a 401k or 403b), up to your employer’s match. Not only does this savings vehicle offer you tax advantages, you are leaving money on the table if your employer matches your contributions and you are not contributing.
For example, let’s say your employer offers a “50% match up the first 6% of your contribution”. This means if you earn $100,000 per year, and save at least $6,000 into this plan, your employer will also add $3,000 to your retirement savings. If you don’t contribute your part, your employer adds nothing, and your benefit is forfeited. Go out and claim the $3,000 your employer has already agreed to pay you before anything else!
- Pay off high interest debt. I’d recommend paying off credit cards or any high interest loans before saving for your emergency fund. This can save you a huge amount of money over time by reducing the interest you will be charged on these loans.
Your emergency fund is designed to prevent you from having to go back into debt. While not ideal, if you pay off your credit cards and an emergency comes up, you can always go back into debt to cover the expense. If you’re at this stage, you should focus on creating a budget and a plan to get out of debt before moving on to other financial planning topics.
- Save for your emergency fund. You want to get the “free” money from your employer match and avoid paying interest and fees on debt before graduating to saving for your emergency fund.
How much should you have in your emergency fund?
Ideal emergency fund balances can vary based on how stable your income is. Generally, you should have about 3-6 months of expenses in your emergency fund. To find out how much you should have in your emergency fund based on your circumstances, use the calculator below.
If you work in a job with potentially unstable future income – consider increasing your emergency fund to 9-12 months of expenses. This will add an extra cushion for those that are:
- At risk of layoffs.
- Business owners with fluctuating revenue.
- Heavily compensated on commission, bonuses, or other income that is not guaranteed.
- In careers that may be challenging to find re-employment if job changes were to occur.
While not having enough in your emergency fund is dangerous, having too much is not ideal either. Once your emergency fund and short-term goals are met, consider investing the rest for retirement or other long-term goals.
You may be leaving opportunity on the table by not having the excess funds invested. Some of the risks of having too much in your emergency fund include:
- Lower long term returns when compared to a diversified investment portfolio.
- Regular savings accounts are not likely to keep up with inflation in the long run.
- Tax inefficiency. Interest is taxed at your marginal tax rate while other investment options may be taxed at lower rates.
If you’re still not sure how much you should have in the bank, use our emergency fund calculator to find out.
Where should I save my emergency fund?
You want your emergency fund to be secure and easily accessible. I generally recommend keeping 3 months of expenses in your checking account, and the rest in a savings or money market account. Common considerations of different account types are below.
|Account||Accessibility||Location||Interest Rate||FDIC Insurance|
|Checking||Easily accessible at your current bank||Your existing bank||Lowest||Yes|
|High Yield Savings||Unless your existing bank offers reasonable rates, you will need to set up a second bank account||Online banks generally offer the easiest account setup and best rates. 2 popular options with competitive rates are:||Intermediate||Yes|
|Money Market||Unless your financial institution offers good money market interest rates, you will need to set up a brokerage account||You can get many different money market mutual funds at brokerage firms. 2 popular low cost options are:||Highest||No|
If you are struggling to build your emergency fund…
I recommend starting with a budget. Make it a priority to save money each month in your emergency fund. If possible, make this automatic through a payroll deduction or ACH from your checking to a savings account. If you need help setting up a budget, some suggestions are:
- Monthly Budget Template
- Create a spreadsheet to track your monthly expenses. Remember to review monthly and update as necessary.
- Link your accounts online to automatically pull in your transactions.
- Like Mint, but instead of being supported with ads, it costs around $11/month.
- A free app for your phone that helps you set up and track your budget, but you manually enter transactions.
- Get organized with a qualified financial planner to help implement your budget and keep you on track.
Monitor and adjust
Once you have attained your ideal emergency fund balance, you should aim to keep that balance within a reasonable range. Let’s say your ideal emergency fund is about $17,000. Of course your bank balance will never be exactly $17,000, but it is wise to set a range around this amount before making a change. For example, if your bank dips below $15,000, you will commit to revisiting your budget and set aside money each month to replenish your bank balance. If your bank balance gets over $20,000, you should have a plan to transfer the excess to an investment account for longer term goals.
However you decide to handle your emergency fund, make sure to build it in as a part of your ongoing financial plan and remember to revisit periodically to ensure you stay on track.