We all know we should have money set aside for emergencies. Here’s how to go about it.
I'm usually pretty sympathetic with my financial advice. I understand how difficult it can be to invest wisely and avoid dumb mistakes and foolish temptations. But on the topic of setting up an emergency fund, I’m quite strict.
Keeping a stash of cash on hand in case of an emergency is essential. The problem is that too few people actually create a dedicated emergency fund.
It’s a big mistake. Bankrate’s 2019 survey on financial security found that just 40% of Americans can cover a $1,000 emergency out of savings. And, of those who faced a financial emergency, 36% said it cost $5,000 or more. The Federal Reserve’s Survey of Household Economics and Decisionmaking found that more than 60% of adults skipped medical, mental health, or dental care in 2018 due to being unable to afford the cost.
Just because you keep a large running balance in your checking account or own a high minimum credit card, you still need an emergency fund. It should be separate from your day-to-day cash to make sure it’s there when you need it. Borrowing to cover an unexpected expense can be the start of a financial hole that’s difficult to dig out of.
Here are six steps to set up and start maintaining a proper emergency fund:
1. A basic savings or money market account is a good option. Ideally it can be linked to your checking account. You want the money accessible in a day, but not in an instant. You want this money to stay safe and liquid. It should not be invested in stocks or even bonds, where it would be subject to market risk*.
2. Look for an account that pays you back. Many savings vehicles offer a small annual yield of around 1%. It’s important to note that some of those may have minimum deposit or balance requirements. Shop around. Make sure there are no annual fees.
3. Stash away enough to cover three to six months of expenses. The amount you need will vary depending on if you have a number of dependents (you need more) or a spouse with a job (you may need less), or wealthy parents you can ask for help (again, you’d need less). If you have one income, are self-employed and have a family to support, you may want up to eight months in an emergency fund (and don’t neglect health and disability insurance).
4. If you don’t have that kind of cash on hand, set up an automatic transfer of, let’s say $100 a month, into the account until you reach your target.
5. Only tap it for true emergencies. This could include your car breaking down, losing your job, the roof starting to leak, or a large medical bill.
6. Replenish the account if you draw on the funds. Unplanned expenses aren’t one and done. They may even come in threes.
Setting up a fund like this may not be a thrill, but I’m confident that you’ll be glad you did. Even if you are the rare individual who doesn’t incur an unplanned expense for years, you’ll still benefit from peace of mind, knowing you have cash at the ready in case something goes wrong.