What is an Emergency Fund?

tl;dr Emergency Fund: Money you set aside is a safe, easy to access place to cover unexpected expenses.

An emergency fund is exactly what it sounds like. A fund you set aside for emergencies. You should be prepared for unexpected things such as:

the loss of a job
large unplanned medical bills
vehicle repairs
appliances (air conditioning, refrigerator, etc) breaking or needing repair

How Much?

You don't need to set aside enough money to cover all of the above scenarios happening all at once, but you should have enough to cover any one of them happening. To cover yourself against unexpected job loss, you should consider how long it would take a person with your education and experience to find a new job in your field. Many people find that three to six months of expenses is a safe amount to save. If you are in an industry with annual hiring cycles (such as education) where finding a new job during the middle of a year not be difficult, you may decide to save enough to cover nine months of expenses.

If you are setting aside six months of expenses, this does not mean that you have to set aside half of your annual income. You only need to save the amount you spend each month multiplied by the number of months you want to cover. For example:

Eliza makes $4,000 / month after taxes. Each month, her spending averages $3,500 for everything she spends money on (groceries, car payment, insurance, her portion of the rent, etc). She decides that she wants to be covered for four months of lost income in case she looses her job. So, she begins a saving plan with a final target of $14,000 (4 x $3,500) in her emergency fund.

Where Does the Money Go?

You've figured out how much to save. Now where do you put the cash? Only a year or two ago interest rates were near zero, and the stock market was at record highs. It would have been very tempting to put your emergency fund into the stock market, but from late 2021 to mid 2022 market index funds/ETFs fell by 25-35%. Markets have recovered some since then, but you would still be down a lot. You could easily see your $10,000 emergency fund lose $3,000 in value at the same time that thousands of people are being laid off and need access to those funds.

Instead, your money should be in low risk and easy to access accounts. For most people this means a bank account. The silver lining of the recent interest rates hikes is that your emergency fund can actually earn a little interest. However, be very careful about keeping your emergency fund in the same account that you use for your debit and credit cards. Even though these checking accounts often have better interest rates than a savings account, it will also tempt you to use your emergency funds for things other than an emergency. For most people, these funds must be in a separate account. If the debit card balance shows $11,000, even though people know $10,000 of that is dedicated to emergencies, they will still spend more money than they would if the balance indicated the true amount of $1,000.

How Do I Get There?

If you don't have an emergency fund saved yet, you're not alone. According to a 2019 Federal Reserve report, 39% of Americans would not cover an unexpected expense of $400 with their savings.¹ The good news is, that you don't have to get there overnight. The important thing is that you start building up your emergency fund so that when the unexpected strikes, you'll be ready.

Take a careful look at your budget and see what you can temporarily cut back on. While it may feel painful to cut back on spending, knowing that it's short term can make it much easier to stick to your plan. From our example above Eliza could start by planning to save three months of expenses in the next year instead of four months. To meet her goal, she would need to set aside $1,166 each month ($1,166 x 12 months = $14,000).

Remember that it's also not an all or nothing system. Don't be discouraged if you can't hit three months of savings in your first year. Having just one month of expenses saved will drastically increase your peace of mind and your ability to cope with that flat tire you didn't see coming. This is one of those times you have to be honest with yourself about where in your budget you can make cuts and which things just can't change.

[1] federalreserve.gov - Published: May 2019 - Report on the Economic Well-Being of U.S. Households in 2018 Photo CC BY 2.0 Rob Oo