If you've been reading about personal finance for longer than 5 seconds, you've probably heard of emergency funds before. That's because emergency funds are one of the most important aspects of personal finance.
However, there are a lot of questions and confusion surrounding emergency funds. That's why I wanted to create this ultimate guide to answer all those common questions and clear up any confusion you may have about emergency funds.
By the end of this post, you'll know:
- What an emergency fund is.
- What emergency funds are for.
- The benefits of having an emergency fund.
- Whether or not you should pay off debt before building an emergency fund.
- How much you should have in your emergency fund.
- How to build an emergency fund.
- Where to keep an emergency fund.
That's a long list, so let's get started!
What is an Emergency Fund?
An emergency fund is a sum of money set aside strictly for emergencies. Simple.
Benefits of Having an Emergency Fund
Here are the two main benefits of having an emergency fund:
- Peace of mind – Imagine having $1,000 stashed away somewhere in case of emergency. Wouldn't you feel a lot more at ease knowing that if life takes a poop on you, you're at least wearing a diaper on your head?
- Money saved – Having an emergency fund can save you a lot of money. How? Because you won't have to borrow money and pay interest to deal with emergencies. You'll already have the money on hand.
What Are Emergency Funds For?
Like I said above, emergency funds are strictly for emergencies only.
But, what is an emergency?
An emergency is something urgent & unexpected that requires money to be solved. This includes things like:
- Job loss
- Medical emergencies
- Car problems
- Home repairs
Emergency funds are not meant for:
- Buying new things
- Buying gifts
- Going on vacation
- Eating out
Now, I know you're smart so I know you can tell the difference between emergencies and non-emergencies. That's the easy part.
What's not easy is committing to using your emergency fund for emergencies only. It's going to be very tempting to use that large sum of cash for other things.
However, if you take out a bit of money here and there for things that aren't emergencies, you're creating a bad habit that could cause problems in the future if an emergency ever were to strike.
That's why you need a better place to keep your emergency fund so it's not as easy to spend, which leads us to the next point:
Best Place to Keep an Emergency Fund
One of the most common questions asked is where to put an emergency fund.
The answer is quite simple:
The key to storing an emergency fund is to make sure the money is easy to access, but not too easy.
For example, I would not recommend keeping your emergency fund in your main bank account. You might get it mixed up with your regular savings, or you might accidentally spend it.
Instead, I recommend keeping your emergency fund in a separate high-interest online savings account. Wealthsimple offers good online savings accounts with a 1.95% interest rate.
Should I Pay Off My Debt Before Building an Emergency Fund?
If you've got credit card debt with a 15-20% interest rate, you've already got an emergency on your hands. That means you should focus all your effort on paying off that credit card debt as quickly as possible. Once it's gone THEN you can start building your emergency fund.
If you're dealing with debt other than credit card debt, you should build a $500-$1,000 emergency fund while you pay off your debt. This will cover any basic emergencies and help you avoid going into credit card debt.
How Much Should You Have in Your Emergency Fund?
The amount you'll want to save in your emergency fund will vary based on your circumstances, but these are the steps I would take if I were just starting to build my emergency fund:
- Build a $500 emergency fund. You can do this quickly by selling things around the house or doing other things to make extra money.
- Build it up to $1,000. Now you've just got to do what you did in step 1, again.
- Cover 3-months of living expenses. To figure this number out, just multiply your monthly expenses by three. If you don't know your avg. monthly expenses, you should learn how to start a budget.
The reason I recommend these three steps is because each time you complete one step, you'll get a little kick of motivation that will help you accomplish the next step. It's all about starting small and working your way up.
Once you complete step 3, it's up to you whether you want to continue to build your emergency fund or leave it as is. Some people will need to cover 6-months or 12-months of living expenses, while others may be comfortable with just 3-months coverage.
The bottom line:
Your emergency fund size will depend on your circumstances.
For example, a freelancer who's income is irregular may want to save more in their emergency fund since they might not know when the next paycheck is coming.
Building an Emergency Fund
There are a lot of different ways to build your emergency fund, but in the end, it all comes down to money. You either need to make more, save more, or both.
Here are some good ways to save money for an emergency fund:
- Save $20 each week. At the end of the year, you'll have $1,040 in your emergency fund.
- Take a percentage off your paycheck. Start with 10% and raise it up as you get more comfortable. If you do this with every paycheck you should be able to build your emergency fund quite quickly.
- Save your tax refund. If you get a tax refund, put it straight into your emergency fund for a quick boost. You only have one chance a year for this one so don't blow it.
- Use an automatic money saving app. This shouldn't be your only source of savings, but it's a good savings side-kick. If you're from Canada (like me) you can use Mylo (full review) to invest your spare change.
- Cut expenses. Assuming you have a budget (learn how to create one), you should look through your expenses and see if you can make any cuts.
- Save the change. Mylo does this for you, but you can also save any spare change you get over the year (think 5-dollar bills, etc.) and put it straight into your emergency fund.
- Make extra money. This is one of the best ways to build your emergency fund quickly. Check out these 20 ways to make extra money on the side.
Keep Working on Your Emergency Fund
Hopefully, you now have a better understanding of emergency funds and why they are such an important part of your personal finances.
Remember that your emergency fund is going to be something you'll have to constantly work on. If you have an emergency and take money out of your emergency fund, you'll have to work on rebuilding it again as soon as possible.
Now I want to hear from you:
Do you have an emergency fund? Why or why not?
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