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Wouldn't it be nice if life came with step-by-step instructions? Now it does! We break down how to master pretty much any money-related task right here in our "How to Do Everything" series. Whatever the goal, we'll cover the steps to take and things to know to reach your next financial milestone, all in one place.
Here, we explain how to start building your emergency fund — an essential first step to a strong financial foundation.
Here's an all-too-common scenario: Everything’s going fine, when suddenly you get into a nasty fender bender. Now you need some fast cash to cover repairs — but your savings are pretty much nonexistent.
You might look to your credit cards, but that can lead to high-interest debt and dings to your credit score. If you had a solid emergency fund in place, however, you’d be ready to cover that expense without having to ring up a costly balance that can take you months, or years, to pay off.
That’s why building an emergency fund is one of the first and most important steps to gaining control of your financial life. It’s meant to act as a safety net when stuff like a job loss, illness or other surprise event you have to pay for (flooded basement, anyone?) threatens your financial stability or your ability to reach money goals.
Growing your emergency savings is easier than you think. Here’s how to get started if you don’t have cash set aside yet for a rainy day.
1. Calculate Your Number
First things first: Determine how much to save in your emergency fund.
Although there’s no perfect number for how much you should stash away, a good benchmark is about six months of your living expenses.
That might sound like a lot, but we’re not expecting you to get there overnight. Ideally, you would start by saving up one month’s worth of expenses before you prioritize any other big financial goal.
Here’s what we mean. Let’s say you’ve been throwing a lot of extra money at your student loans to pay them off sooner, but you might want to hold off on getting that aggressive until you have that one month amount saved up. Once you reach that benchmark, you can put extra toward debt again while also making sure you’re still adding to your emergency fund bit by bit until you reach six months.
So how do you know what your expenses are, anyway? Avoid guessing and take the time to figure out how much you spend every month in these main buckets.
- Fixed monthly expenses: These are recurring costs like rent, utilities or car payments that don’t fluctuate too much from month to month.
- Minimum debt payments: This is the amount you have to pay each month to keep up with your loans, credit cards and other debts.
- Non-monthly expenses: These are costs that you have to pay once or a few times a year, like insurance premiums, holiday travel or car registration fees. You can prepare for them ahead of time by adding up your total non-monthly expenses and dividing that sum by 12 — this is how much you’d set aside each month to ensure you have enough to cover those costs when they roll around.
- Flexible spending: These are costs like food, clothes, entertainment and other discretionary spending that can vary widely from month to month.
2. Open a Separate Savings Account
In order for your emergency fund to be effective, it must be both safe and readily available. By that, we mean in an FDIC-insured account that you can access easily if you need quick emergency cash. A good option would be a high-interest savings account at a trusted online or brick-and-mortar bank with FDIC insurance. That way, your money is earning some interest while also easy to access.
Consequently, here’s where you probably shouldn’t stash your emergency fund:
- Under the mattress. Keeping actual cash close at hand might sound like a good idea, but your money could easily get lost, stolen or destroyed.
- In the stock market. True, you may be able to grow your money faster than in a savings account, but you’re also taking on risk that could cause you to lose some or all of this critical cash. Plus, if you were to sell off investments to help pay for an emergency, you might have to pay taxes on your gains.
- In locked accounts. By locked, we mean certificates of deposit or other types of financial accounts that force you to jump through hoops — including possible early-withdrawal penalties — in order to take your money out before a designated timeline.
- Your checking account. Relatively speaking, this isn’t the worst place to leave your emergency fund, but if you keep it in your checking account, you’re likely to use it for something other than an emergency. Ideally, the bank that holds your savings account will also be different from the one that holds your checking account so you won’t be as tempted to make an easy transfer for a non-emergency.
3. Brainstorm Ways to Save
You might think you don’t have a lot of extra cash to devote to building your emergency fund right now, but you can gradually reach your goal with some intentional saving and a little creativity.
Here are some ideas to get you started:
- Start small and build momentum. Pick an achievable goal and grow it from there. Maybe it’s just $50 a month or 1% of your paycheck. As you get accustomed to setting aside that amount, consider increasing it over time. Setting up a recurring transfer from your checking to your savings can help make sure you’re not neglecting that emergency fund.
- See where you can free up cash. Is there a subscription you don’t need anymore, or could you cook one more day a week and eat out less? Divert that saved money into your emergency fund.
- Stash away any windfall money. Did you get a tax refund, your annual work bonus or even a surprise inheritance? Deposit some (or all!) of that bonus money into your emergency fund.
4. Reassess Your Fund From Time to Time
Once you have a system in place for saving, tweak your plan as needed. See what elements of your strategy aren’t working and where you’re willing to do even more. Motivate yourself by tracking your progress toward your target number. And celebrate when you reach that goal!
Remember to review your emergency fund regularly. Life brings changes, so you may need to adjust your target dollar amount if you buy a house, have a kid or face some other increase in your expenses.
Finally, once you’ve reached your emergency fund goal, look ahead to what’s next. With a solid buffer in place, you’re in a better position to pay off debt faster, put more toward retirement, start saving for a home down payment or plan that vacation of your dreams. If (or rather, when) you do tap your emergency fund, remember to replenish it as quickly as you can to keep your safety net intact — that way you'll be prepared for the next emergency that may come your way.