There is nothing that will derail your goals of becoming financially independent, or financially solvent, or debt-free, or on track for a great retirement, than not having an emergency fund.
As the name suggests, an emergency fund is a stash of money set aside to cover living expenses in case of an emergency like a job loss, unexpected medical need or last-minute car repair. But how much money you should have in that fund depends on your income and your financial obligations, especially basics such as rent, utilities and food.
Your emergency fund should be used only as a last resort for real emergencies, once other strategies such as reducing your expenses have been exhausted. Making that commitment will mean you'll have access to this money when you truly need it, something you'll be grateful for.
Your emergency fund should be separate from your regular checking and savings accounts, and it should be filled with money only for emergencies. It's best to put your emergency money in an account that earns interest instead of stuffing it under your mattress. Do not use it to invest in the stock market.
If an emergency such as job loss unfortunately arises, you can pull money from the fund to make sure you can keep a roof over your head, stock up the refrigerator and make all your bill payments on time. Since an emergency fund doesn't need to be paid back with interest, it's usually the wiser choice over other potentially costly methods of borrowing money, such as withdrawing money from a retirement account, using a personal loan or relying on your credit cards.
Initially, if you don't have an emergency fund, set a goal of $1,000. This may seem small, but you have to start somewhere, and $1,000 seems more obtainable than $20,000 or more. Once you've reached $1,000, you can add to that monthly until you've reached three to six months of living expenses. Even $1,000 can be a financial boon if the car needs a repair or the water heater goes out. If you have to use some of these funds, be sure to pay it back as soon as possible.
Everything financial begins with a budget
Starting an emergency fund begins with setting a budget. Calculate your monthly income and expenses: How much money is coming in and how much is going out?
A spreadsheet or a budget app can serve as the foundation for your plan, enabling you to carefully track your spending and stay on top of how much money you can carve out for your emergency fund.
Once you've done the math, look at how much money is left after taking care of basic living expenses, credit card bills, loan payments and so forth. Does the math indicate you're basically living paycheck to paycheck? If so, it's time to find ways to cut costs:
- Tackle your credit card debt. When you reduce or eliminate that debt, you can free up money for the emergency fund. Paying down your credit cards can also help you raise your credit scores.
- Decrease discretionary spending. This is spending on things other than the necessities, such as your gym membership or entertainment. Look at where you could stand to cut back here, and put this "found" money toward your emergency fund.
- Find ways to reduce your bills. Making a call to your cellphone provider, insurance agent and other businesses you make payments to every month can sometimes result in savings if you simply ask. Some companies can provide special rates for customers who call to cancel an account, for instance.
When you have your budget set, and your savings plan outlined, the "set and forget" method can pay off. By setting up automatic transfers from your bank account to your emergency fund, you won't need to think about making those deposits. You might even look into a direct-deposit arrangement, allowing you to automatically steer a portion of your paycheck to your emergency fund.
An emergency fund can be a lifeline when you confront unexpected circumstances, allowing you to have a place to live, put food on the table, pay utility bills and keep pace with credit card and loan payments.
Establishing an emergency fund can be one of the best gifts you can give your future self. And it can be simple to do, as long as you put together a budget, watch your spending and stick to your savings goal.