We've all been caught off guard with an emergency payment - from having to replace an appliance to an unexpected medical bill. These things happen and they're out of our control, so it's best to be prepared. Emergency funds are the best way to protect yourself, and a great way to start building your savings.
These unforeseen expenses shouldn't cripple your savings. With an emergency savings fund, you can recover more quickly and get back on track to achieving your financial goals with little to no stress.
What is an emergency fund?
An emergency fund is easily accessible money stored in a bank account set aside specifically for unexpected expenses or financial emergencies, anything from medical expenses to a loss of income. Emergency savings are typically used for unplanned expenses that fall outside of your normal monthly spending, with the funds stored in a savings account.
These funds allow you to weather the storm and avoid the need (and costs) of taking out a high-interest loan or credit card debt. Keeping the funds in a savings account removes the temptation to spend it, as would be the case if you stored the funds in a checking account.
Why emergency savings are important
Emergency or unexpected expenses without the proper precautions can quickly turn into debt or take a toll on your savings goals. And if hit with two or more in a row, this might cause long-term consequences that cause havoc on your finances.
Rather rest assured knowing that you have an emergency fund in place should something unexpected happen than fall back on costly loans and credit cards, or even other savings accounts like your retirement savings.
Emergency funds play an essential role in any reliable financial plan, providing peace of mind and a buffer for your other savings accounts. These funds can be used during periods of unemployment, the sudden death of a family member, illness and disability, or emergency home and auto repairs. Never underestimate the importance of an emergency fund and its impact on your financial well-being should something go wrong.
Start your emergency fund with these 7 simple steps
1. Review your monthly budget and see where you can save
It's critical to understand where your money is going so you can find ways to save it. Budgeting allows you to maximize your income and discover methods to decrease or control your spending.
To do this you can sit down with a financial advisor, or take matters into your own hand with your checking account statements, a pen and paper or a budgeting app. Be sure to review both your checking and savings accounts to get a clear picture. This is the first step in improving your financial health, and to start building your emergency fund.
2. Establish a goal amount for your emergency fund
A budget is a plan for spending that helps you figure out how much money you'll need each month to meet your essential expenses. A general rule of thumb when looking to build an emergency fund goal is to aim for six months' worth of income, enough to cover monthly expenses for housing, food, and transportation.
Don't be discouraged by how long this will take, rather establish a goal to work towards and move forward in that direction. Ideally, you want to be able to cover your living expenses for six months.
3. Create a direct deposit to your savings account
Avoid temptation by setting up a direct deposit from your current bank account (or wherever you receive your income) to your savings account. Better yet, you can create a split direct debit which allows you to automatically allocate funds to various accounts, including retirement funds etc.
If you're new to saving, experts recommend starting with an emergency fund, and once you've established this, move on to other savings accounts. If you already have a retirement fund or money market account set up, continue with this while building your emergency fund.
4. Little by little increase your savings
Increase the amount you're putting into your emergency fund by 1 percent or a certain amount over time until you've reached your savings goal. Increasing amounts gradually might help to make the smaller deposit into your checking account seem less noticeable and steadily build financial security.
5. Direct any unexpected income straight to your savings accounts
Commit to redirecting any unexpected income to your emergency fund, at least until you have reached your saving goal. This might be money from a bonus, inheritance, a tax refund, lottery winnings etc.
6. And once you've reached your goal? Save some more
Being unemployed for more than a year or being hospitalized for several months are both situations that require more than a six-month cushion. Should you find yourself here you’ll be glad you have more money saved in your emergency fund.
7. Find a bank account with perks that can kickstart your savings
When opening new checking or savings accounts, shop around by observing bank or credit union offers. Some banks offer cash incentives to new customers. Use this to kickstart your emergency fund, or to add a little extra to an already established one.
In conclusion
An emergency fund provides a cushion for unplanned events and can help you avoid taking on credit card debt or taking out a personal loan. By putting your emergency money in a high-yield savings account as opposed to checking and savings accounts, you can earn interest while you save money and build your nest egg.
Having an emergency fund saved in a separate account prevents you from spending the money and ensures that it is accessible in the case of an emergency. Emergencies can occur whether or not you are prepared; as a result, being prepared is the best way to deal with a potentially difficult scenario.