What is an Emergency Fund? Do I Really Need One?

Banking
Updated: 27th Feb 2021
Written by Kim Pinnelli
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Banking
February 27, 2021
Written by Kim Pinnelli

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No one likes emergencies, but they’re a part of life, right? You’re better off being prepared than putting yourself in financial distress because you can’t cover the problem.

An emergency fund solves these problems and more. Everyone needs one, but no two emergency accounts are the same.

What is an Emergency Fund?

An emergency fund is an account you use in an EMERGENCY. Only use the funds for serious issues – job loss, a serious car accident, a major illness, or an unexpected house repair are a few examples.

Start with a $1,000 emergency fund to make it easier on yourself but work your way up to saving 3 to 6 months of expenses.

Do I Need an Emergency Fund?

EVERYONE needs an emergency fund. No one is immune to what life can throw at them. Your car could break down, your A/C need replacing, or you could fall ill and need serious medical assistance.

What if you lose your job or your self-employment doesn’t work out?

The sky is the limit regarding the emergencies that can happen no matter your life circumstances, which is why you need an emergency fund.

How Do Emergency Funds Work?

An emergency fund is a savings account you keep separate from any other funds. It’s best to open a high yield online savings account to earn the most interest on your funds, but any account you won’t touch works.

You contribute to the fund until it has as much money as you think will get you through even the worst emergency. If you use any of the funds (for an emergency), start again, saving until you hit your ‘magical number.’

Learn More: Best Bank Accounts

How to Build an Emergency Fund (Step-by-Step)

First, set goals for your emergency fund. You aren’t going to save thousands of dollars in a few months, so be realistic with yourself:

#1. Set a small goal

Don’t overwhelm yourself by setting a goal to immediately save 6 months of expenses. Make it small, even $100 to start. Prove to yourself you can do it.

#2. Increase your goal

Next, raise your goal to $1,000. While not enough for a serious emergency, $1,000 can get you through many basic emergencies.

#3. Save up to 6 months of expenses

Finally, look at your total monthly expenses and multiply them by 6 months. This is your ultimate goal.

Once you know how much to save, create a plan using these steps:

#4. Create a budget

If you don’t have a budget, make one. If you have one already, revisit it. How much money can you set aside monthly for your emergency fund? Make it a line item in your budget each month.

#5. Open a high yield savings account

Don’t keep your money in your checking account or even a local savings account. The money is too easily accessed.

Open a high-yield savings account online that pays higher interest rates and is harder to access.

#6. Keep saving

Even when you think you have enough, keep going. If you spend any money from your emergency fund, replenish it, adding the line item back into your budget if you removed it because you had enough saved.

Related: Best Budgeting Apps

Where Do I Put My Emergency Fund?

I prefer keeping your emergency fund in a high yield savings account, but there are a few other options.

  • High-Yield Savings Account: Like I said earlier, why not earn higher APYs on money that will just sit, hopefully for the long term?
  • Regular Savings Account (Set Aside): If you aren’t tempted to spend money kept at your local bank alongside your checking account, you can use a regular savings account. Remember, you’ll earn less interest and have easier access to the funds.
  • No-Penalty CD: A liquid CD may pay a slightly higher APY but has the option to withdraw funds whenever you want. Stay away from traditional CDs, or you’ll pay a hefty penalty for withdrawing your own funds if you have an emergency.

Learn More: Best CD Rates

Why Do I Need an Emergency Fund?

Everyone needs an emergency fund because life happens. If your car breaks down or your A/C breaks, would you rather have the cash available or have to rack up credit card debt or take out a loan?

Emergencies are stressful enough without adding financial stress on them too.

How Much Should You Have in an Emergency Fund?

Ideally, you should have 6 months of expenses in an emergency fund. For example, if your expenses are $4,000 a month, you should eventually have $24,000 saved.

Is a $1,000 emergency fund enough?

A $1,000 emergency fund will get you through a basic emergency and is a great starter point.

Don’t stop there, though. If you lost your job or fell ill, $1,000 would not help you.

Is an Emergency Fund the Same as a Savings Account?

An emergency fund is like a savings account. You may keep your funds in a savings account, but only if you’ll reserve them for true emergencies.

Never keep the money in your checking account, though, it is too tempting to spend the funds or lose track and spend what you shouldn’t.

Bottom Line: What Is an Emergency Fund?

Life is going to throw you curveballs, so you might as well be prepared. An emergency fund ensures you can get through the issue financially without too much stress.

Why worry about money when you could focus your efforts on other issues?

Kim Pinnelli
Kim Pinnelli
Kim is a personal finance expert with a Bachelor’s degree in Finance from the University of Illinois at Chicago. She has been freelance writing for 13 years for a number of large publications. Kim thoroughly enjoys helping people take charge of their personal finances.