An emergency fund is a key component of any good financial plan. It prevents you from having to borrow money to cover unexpected expenses, which would only add onto the debt load you already have.
According to a 2022 survey by Bankrate, 56% of Americans don’t have enough money in their savings accounts to cover an unexpected $1,000 expense. An emergency fund can provide financial security during unexpected events such as job loss, medical emergencies, auto repairs (if your car is your primary mode of transportation), and any urgent home expenses, and can help you avoid relying on high interest credit cards or personal loans.
The good news is that saving even a small amount per month will eventually get you to your goal. It just takes time and discipline.
How to build an emergency fund (step by step)
Creating an emergency fund is simple. Here’s a detailed step-by-step breakdown of how to get started.
Step 1: Figure out how much you spend each month.
Start by monitoring your monthly income and expenses. This will give you a bird’s-eye view on your finances so you can understand where your money is going and identify areas where you can cut back or save more.
Step 2: Filter out unnecessary expenses.
Review your expenses and find areas where you can cut back. This might include reducing eating out, entertainment expenses, or cancelling unused subscriptions.
Step 3: Calculate your essential spending.
These are expenses that are unavoidable, like housing (rent or mortgage payments), utilities, transportation, food, and any high-interest loan payments.
Step 4: Set a financial goal.
Now that you know how much you need to cover your essentials. Determine how much money you want to save in your emergency fund. You should generally shoot for around 3 to 6 months’ worth of living expenses as a target. For example, if you need $2,000 minimum to cover your essential expenses, ideally, you would want to have $6,000 to $12,000 saved up to cover you for 3 to 6 months.
Step 5: Automate your savings.
Set up an automatic transfer from your checking account to a separate savings account designated for your emergency fund. This way, you won’t have to rely on remembering to save; it will happen automatically.
Step 6: Find ways to increase your income.
Consider ways to increase your earnings, such as asking your employer for a raise, taking on a side hustle, or freelancing. This extra income can be dedicated to building your emergency fund faster.
Step 7: Minimize your debt.
Reduce any high-interest debt as much as possible. By paying down debts, you’ll have more disposable income to contribute to your emergency fund. Additionally, having less debt will decrease your financial vulnerability during emergencies.
Step 8: Save windfalls and bonuses.
Whenever you receive unexpected money, such as tax refunds, work bonuses, or monetary gifts, allocate a portion or all of it to your emergency fund. This can accelerate your savings progress.
Step 9: Review and adjust your plan.
Regularly evaluate your progress and make adjustments as necessary. If your living expenses change or your financial situation improves, you may need to revise your savings goals or increase your contributions.
Step 10: Maintain discipline as you save.
It’s crucial to stay committed to your savings plan and avoid dipping into your emergency fund for non-emergency purposes. Remember that the fund is designed to provide a financial safety net for unexpected situations. This account should only be used in emergencies, not when you’re short on cash for a luxury purchase.
Where should you keep your savings?
An emergency fund should be kept separate from your daily spending accounts, and remain safe and liquid. Ideally, it should be kept in a high-interest savings account with zero fees. It should be quickly accessible, and not be subject to market risk (ie. don’t be investing it into crypto, or even traditional assets like stocks or ETFs).
How much should you save in an emergency fund?
Ideally, you should aim for at least 3 to 6 months of essential living expenses. The goal isn’t to replace your entire monthly income, but enough to cover essential expenses like housing, utilities, transportation, food, and any monthly debt obligations like credit card or loan payments. It should not cover luxuries like eating out or playing golf on the weekends.
To determine how much you need to save, calculate your essential monthly costs each month by adding up all of your essential expenses over the past few months. Your number will vary depending on if you have dependents, a spouse with a job, or any other forms of passive income you can rely on.
How much should you try to save each month?
If you already feel like you’re just getting by without putting any money aside, start small. Set up an automatic transfer from your checking account that puts a small portion of your paycheck into your fund each month. This can be as little as $50 or $100 a month. As you start getting more comfortable setting money aside, you can slowly increase your deposit amounts overtime.