Growing your savings and having a dedicated emergency fund, in particular, can have a huge cumulative effect on your lifestyle and on your long-term quality of life. As we get older, life’s truisms tend to prove themselves true again and again, with one of the primary lessons being that nothing stays that same. Jobs change (or go away altogether), the once-new and reliable car you bought begins to show its years and requires expensive repairs, we get married (or divorced), and some of us have children — which changes everything.

Unexpected expenses become an expected part of adult life, but we aren’t always sure which ones to expect or how much it will cost. This uncertainty is what makes an emergency fund essential.

Every year the Federal Reserve publishes its Report on the Economic Well-Being
of U.S. Households, a report we watch closely because it contains some telling information on how we’re doing collectively in regard to our finances. In 2013, half of the adults surveyed indicated that they could not cover an unexpected $400 expense with their savings. In many cases, the only way to pay the unexpected expense is with credit.¹

Fast forward to 2018. The newest report from the Federal Reserve now shows that the number of households who can’t easily cover a $400 emergency expense is down to 40%. While that’s a notable improvement, it still means that if you put ten adults in a room, four of them are low on options and may need to use credit. That’s an unsettling thought, but not one without a solution on an individual level.

Economic realities: the cost of things going wrong

Sometimes, things just don’t go as smoothly as we’d hoped. It’s a fact that there are fewer financial emergencies when you plan for the likely contingencies. In this case, planning means saving. The challenge is that you don’t know which things will go wrong or break or just happen — and that sometimes, emergencies can’t easily be predicted, like in the case of sudden injuries or illnesses.

Consider some of the biggest risks, however, one of which is likely to be losing your job or losing a primary source of income. Companies move, close, or change priorities and often employees are the last to know that their livelihoods are at risk.

The numbers vary depending on where you live and by industry but finding a new job can take months. An expert from Monster.com, a well-known job search website with over two decades in the business, puts a best-case estimate at about three months from the day you start your search until the day you start at a new job.² Of course, some will land a job sooner. Some will also face setbacks that can push that date back by weeks or even months.

How long could you survive without income or with a deep cut to your income due to losing your job? If you’re among those that might struggle with a $400 surprise expense, this type of setback can be difficult to recover from.

In addition to the possibility of a job loss, some other good reasons to have an emergency fund include:

• Medical or dental emergencies
• Home repairs
• Car repairs
• Travel expenses, such as lost luggage
• Property tax or income tax bill
• Unexpected pay reduction
• Caring for someone else
• Identity theft or lost access to your bank account
• Changing jobs
• Moving
• Emergency trip due to death or illness
• Funeral costs
• Emergency pet care

Any of these situations could cost hundreds or even thousands of dollars in unexpected expenses. With an emergency fund, you’ll be able to cover all or at least part of the cost without accessing costly credit.

Benefits of having an emergency fund

How much more confident would you feel if you had six months worth of savings stashed away? How much more confident would your spouse, roommate, or significant other feel is they knew there was a safety net in place? Money is one of the leading causes of stress, specifically concerns about not having enough of it. Having a well-funded emergency fund in place reduces money-related stress and provides you with options. If life throws some surprises your way, you won’t feel trapped by circumstances.

You’ll also be able to stay off the credit merry-go-round. Without an emergency fund in place, unexpected expenses often end up on credit cards with interest rates of 15% or even higher.

You can also take another look at your insurance policies or extended warranties you’ve purchased, another type of insurance. With a well-funded emergency fund, it might be less expensive in the long run to cover some of these expenses yourself. Maybe higher insurance deductibles are in order, which can save you some additional money every month on your insurance premiums.

Costs of not having an emergency fund

If a $400 emergency comes your way and you’re unprepared, many people would have to turn to credit to cover the expense. At 15% interest and with a minimum payment of $15 per month, that $400 emergency can cost an additional $90 in interest expense and will take nearly three years to pay off. It’s entirely possible that another $400 emergency will come along during those three years, making credit card interest a fixed item in your budget and one that never goes away — unless you focus on building your emergency fund, even if it means making some sacrifices to find the extra money.

How to start your emergency fund

Ideally, you’ve already built a budget. If so, your emergency savings should be listed as a budget item. It might take some time to build your emergency fund. With patience and with a goal in mind, you’ll get there in time.

Look for expenses that happen routinely that may not need to happen so often. Maybe you have a Friday night pizza habit or a 5-day-a-week gourmet coffee habit. Obviously, these are things you enjoy but their costs can add up over time. The pizza habit, just an example, could cost as much as $1,000 per year and the coffee habit might be over $2,500 per year. Many of us make these kind of “small” expenditures regularly without thinking twice about how much it really costs over the course of a month or a year. Consider cutting back and redirecting the money to your emergency fund.

Also look for subscriptions and other bills that might automatically renew. Do you still use the services that you’re being billed for? Perhaps some of these expenses can go away. Redirect that (saved) money toward your emergency fund as well.

Your emergency fund is a team effort

If you are married or share household expenses with someone else, the emergency fund needs to be a priority for everyone. If one partner is cutting back and the other is spending just like before, your emergency fund has less chance to build and money or spending can become a source of friction. Invest the time to have a respectful conversation about goals and decide beforehand — as a team — where you can cut spending to fund your emergency savings. The benefits of a well-funded emergency fund will benefit everyone but will require teamwork from everyone as well.

How much money do you need in your emergency fund?

If your bank account is empty or nearly so, this can seem like a loaded question. Like many goals, the goal of building your emergency fund is best done in steps or milestones. It’s a marathon and will require perseverance but by breaking a larger goal into smaller goals, you’ll be encouraged by your success as you reach each milestone. In the short term, you might choose $250 or $500 as a first goal. With discipline, most households should find this goal attainable. As you reach your first goal set another. While $500 can help you navigate a smaller emergency, it won’t be enough to cover life’s more expensive emergencies. Consider setting your next goal at $1,000.

In the long run, you want to have enough in your emergency fund to cover the big emergencies, like losing your job. Many financial experts recommend saving enough to cover five months worth of income. This should be enough to carry you through until you can replace the income with another job or find a way to make money on your own, perhaps in your own business or freelancing.

What type of account should I have for my emergency fund?

Out of sight is out of mind, as the old saying goes, and the same wisdom is true for your emergency fund. You don’t want to keep your emergency savings in the same account as your regular checking or savings account. Part of the reasoning is to give your emergency account “special status” but the primary goal is to keep your emergency savings out of harm’s way. If your emergency funds are co-mingled with your other funds, sooner or later, the money is likely to be spent. Keeping your emergency fund separate creates an extra step that will make you think twice before spending the money you worked so hard to earn and to save.

You’ll also want your money to be accessible. When an emergency happens, waiting a few days or longer before you can access your money could force you to use credit. Look for options that allow you to access your money easily if needed.

Your bank may offer a competitive rate for savings accounts or rates might be on the low side, but don’t let interest rates be a deciding factor when you’re just starting out with your emergency savings. Convenience is a higher priority than the interest rate. The interest on $500 at many banks is probably less than $10 per year, so this shouldn’t sway your decision. As you grow your emergency savings, you can look at options that provide a better return but still provide access to your money.

You’ll want to avoid Certificates of Deposit as a way to grow your emergency savings. Even if the interest rate is much higher with a CD than a standard savings account or money market account, your money isn’t easy to access and you might be charged a penalty for early withdrawal if you need to cash in the CD before maturity.

Consider a standard savings account when you’re just getting started. As the balance grows, you might consider a money market account. Be aware that many money market accounts can have minimum balance requirements and may restrict how many times per month you can withdraw from your account.

What should I do with the surplus savings?

If you’ve reached a point where you are wondering what to do with the surplus, you’re in a much stronger financial position. Before you spend the extra money on a trip to Disney, be sure your budget is in good shape and is surviving the test of time. Budgets tend to show true(er) numbers as time goes on. In particular, you’ll want to be sure you’re saving enough for larger expenses that happen occasionally, like car repairs or home repairs. These items can be tougher to budget for than fixed monthly expenses, so you’ll want to take another look at your average spending for these budget categories and be sure you’ve put aside enough. If not, direct the surplus to these budget items first.

Check your debt. If you have some lingering credit card bills or other high-interest debt, put the surplus to work here. The average credit card interest rate is about 15% and the interest is paid with after-tax money, meaning for every dollar you pay in interest you may need to earn between $1.30 and $1.40, depending on your tax bracket. A dollar saved could be a $1.40 earned when it comes to interest savings.

If your debt is in good shape and you still have some money left over, you might consider increasing your contribution to your IRA or another investment account. Your future self will thank you for being so wise with your money now.

Endnotes

1. https://www.federalreserve.gov/publications/files/2017-report-economic-well-being-us-households-201805.pdf

2. https://www.monster.com/career-advice/article/how-long-does-it-take-to-get-a-job-0117