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October 27, 2020

Why emergency funds are important

There’s nothing complicated about the purpose of emergency funds: an emergency fund consists of money set aside for unexpected events that happen in life, like if your new-ish car breaks down or you get laid off. This money can help you cover the sudden expense or keep life going as normally as possible under the circumstances. It also protects you from resorting to credit cards, payday loans, or lines of credit. All of these carry high interest rates and can lead to a spiral of interest debt – some payday loans have an astronomical annual interest rate of 440%!

How much do you need to save?

Emergencies can range from a few hundred dollars to thousands of dollars, so figuring out how much to keep in an emergency fund can be a balancing act. At the same time, it doesn’t have to be complicated at all.

The traditional advice is to save three to six months of expenses in an emergency fund. If you’re just starting out, this can feel like a daunting number but remember: the goal is to build up to this amount. We’ll give you some tips below to start saving up, but even $10 a week adds up.

If you feel a sense of unease at the traditional advice, don’t ignore it! You might be in a more cyclical industry or in a riskier career, or maybe you simply have kids or parents who depend on you financially. In that case, having a year’s worth of expenses might be the long term emergency fund goal for you.

  1. Start by opening a separate savings account

No need to overthink this step – just start somewhere. If you’re confused between opening an account between two banks, wondering what kind of account you need to open, or waiting for the interest rates to go up before starting, you might be hurting yourself in the long run.

In less than 15 minutes, you can find a bank that gives you competitive savings account rates and low fees because most banks offer almost exactly the same kind of features in savings accounts. Simply pick one and start saving – if you find a truly remarkable bank a few months down the road it does not take very long to transfer accounts.

If it’s truly so easy, you might be wondering, why not just keep the money in your checking account? Having a separate savings account builds a mental wall between the money you can spend for normal everyday expenses, and the money you shouldn’t use unless it’s a true emergency.

  1. Break down your goal into smaller steps

Now that you know how much you need to save, set a monthly or biweekly savings goal to build up to that amount. This will get you into the habit of saving regularly and also give you a little mental boost every time you add a little bit more money to your fund.

Building habits is extremely important when it comes to saving money. If you don’t practice saving at every opportunity you can, it will become tempting to withdraw money from the ‘emergency’ fund for things that aren’t true emergencies.

Breaking down your goal and aligning it with pay cycles also gets you in the habit of paying yourself first. The easiest way to approach this step is to treat your emergency fund as you would a bill. Incorporate your fund contributions into your budget and make it a point to make a payment at least once a month, as you would for your other bills. If you approach your fund as a bill, you’ll prioritize where your money goes.

  1. Start by saving a realistic amount

When you set a monthly goal, pick a contribution amount that is affordable, realistic, and consistent. Don’t assume that you’re suddenly going to be able to save a lot more money just because you’ve made the decision to do so (although that is important too). Focus on changing money habits in a way that is sustainable, just like you would for mental or physical health goals.

Even a small amount every week or every month will go a long way in establishing an emergency fund, while teaching you good money habits and instilling financial discipline in your life.

  1. Increase your emergency fund

The regular, consistent savings you make will form the bulk of your emergency fund, but don’t let opportunities for supercharging your emergency fund go to waste. Deposit additional amounts into your savings account whenever possible. For example, if you:

Use the extra money to increase your emergency fund. You should still treat yourself (especially if you get birthday money) but do so responsibly. Set a ratio of spending versus saving: for example, treat yourself to something nice with ½ of your birthday gift money, and save the other ½.

Additionally, you can use apps like Acorns and Chime to sneakily round up your transactions to contribute to your savings account. While this cannot be your primary method of saving, and it can subconsciously impact your spending habits (so use with caution), it can be a fun way to add to your savings.

  1. Eliminate an expense and save the amount

Think about an expense in your current spending that you could cut out without too much of a difference. Analyze your budget (or make a budget, reading our tips here, and identify your needs and wants:

Need: a necessity, an obligation, something essential

Want: a desire, a wish, something non-essential

To eliminate an unnecessary expense, you could:

Depending on your current habits, that could be a lot of extra money to your emergency fund.

  1. Know when to use your emergency fund

Lastly, it’s very important to be honest with yourself about what constitutes a true emergency. Expenses that happen irregularly or spending you could’ve predicted are not emergencies.

Let’s look at a couple of examples:

While your emergency fund should be easy to access, it’s very important not to let yourself be tempted by this money and to leave it intact for a real emergency. On the other hand, when it’s truly an emergency, don’t hesitate to use your emergency fund. It’s much better than costly options such as payday loans or credit card cash advances. The purpose of an emergency fund is to avoid resorting to these expensive options.

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