What is an emergency fund?

If you were hit with an unexpected bill for $400, could you pay it?

A recent study by YouGov for the Economic Security Project found that half of all Americans don’t have $400 in spare cash to cover an emergency expense. 

For larger expenses, no doubt even fewer people have that amount saved in an emergency fund.

So what is an emergency fund? How much should you have in one? And where should you keep that money?

What is an emergency fund?

An emergency fund is cash set aside for, well, an emergency: to cover the deductible if you’re in a car accident, to pay for a home repair or new refrigerator when yours dies, or to tide you over while you’re job hunting if you lose your job. 

It isn’t a bank account that you tap regularly to cover normal, expected bills. It truly exists for unexpected expenses.

Think of it as a safety net or a buffer: a safety net that can save you from significant financial consequences.

Why do you need an emergency fund?

Without the safety net of an emergency fund, any unexpected bill can mean a financial disaster. 

Even for someone with excellent credit, running up a credit card balance or missing payments because of a surprise expense can cause a credit score to drop quickly. 

And recovering from a significant financial blow can take months or years, or even potentially lead to bankruptcy.

There are significant psychological benefits to having a robust emergency fund as well. You might sleep better knowing more financial freedom to make the decisions that are best for you, knowing you have a financial safety net if something bad happens. 

Company announces layoffs? You have a cushion while you find a new job, which means you’ll have less stress and you don’t necessarily have to take the first job offer you receive.

How much should be in your emergency fund?

For most people, a solid emergency fund should have enough to cover 3-6 months of expenses. That rule of thumb will vary, though. If a partner or someone else is providing some of the household income, you may need less in your emergency fund. If you’re responsible financially for someone else, such as a child, or work in a volatile industry or for a company with high turnover, you may want to set aside more.

Finally, what would it take for you to have peace of mind and not worry about an unexpected expense? Some people have emergency funds that can cover a year of expenses. It all depends on where your emergency fund fits into your financial life.

Where should I keep my emergency fund?

It’s critical that money in your emergency fund is safe and secure. And safety means no risk. Your emergency fund is designed for just that, emergencies. So you want to make sure it is accessible (liquid) in the event something unexpected happens.

Your emergency fund is a critical part of the foundation for your financial planning, which also includes saving for important goals, paying down high interest rate debt, having proper asset protection through insurance, and having a basic estate plan in place.

Although current interest rates are low, keep in mind that your priorities for your emergency fund are safety, security, and a predictable return. Look online for high-yield savings accounts. That gives you easy access to your emergency fund and, as an added bonus, offers a much higher interest rate than most banks, usually around 1%. 

They are FDIC insured up to $250,000 (per individual) and easy to set up. A great resource to find a good high yield savings account is here.

How can I build my emergency fund?

Get started on your emergency fund ASAP, even if you have to start small. If your employer offers direct deposit to more than one account, have a portion of your paycheck deposited into your emergency fund before you even see it. If not, adopt the mindset of “pay yourself first” and set up an automatic transfer every payday from your regular bank or credit union account into your emergency fund. Again, even if initially it isn’t a lot, build a habit of regularly contributing to your emergency fund.

To boost the amount you can afford to earmark for your emergency fund, consider starting or building a side hustle. Whether you paint someone’s house, drive, deliver, sell on Etsy, or turn a hobby into a money-maker, another source of income can make it easier to build a solid emergency fund. Commit to putting a certain percentage of your side hustle into your emergency fund each week.