The emergency fund has a scary name even though it can be used for not-so-scary reasons. If you want to understand Finance 101, emergency funds are at the top of the list. Every financial advisor is trained to look for an emergency fund before they kick off any other evaluation. So what is this emergency fund and why is it so important?
What is it?
The “emergency fund” or “rainy day fund”, as it’s commonly known, gets its name from a literal definition. It is a fund or pool of money you should set aside for a spending emergency. More importantly, everyone, even the wealthiest of individuals, must have easy access to cash should they need it. If 100% of your savings is tied up in investments or real estate, for example, you would not be able to get cash out immediately. Additionally, with investments, there is a risk of losing money. For others, your expenses may be so close to your monthly paycheck that the credit card becomes the emergency fund. This too, is a problem.
It is important to understand what types of events or purchases qualify as emergencies versus those that should be saved for separately. When it comes to emergencies, we define these events as unplanned and in most cases required spending. Here are some examples:
- Loss of job
- Large car maintenance bill
- Unexpected family death or emergency that requires last minute travel purchase
- Unexpected medical bills (note, expected medical bills will be in the next category)
- Major unexpected but necessary home repairs
These events cannot be planned for and therefore need to have a savings account at the ready. Sure, these can go on a credit card but only if they will be paid off immediately from the emergency fund. Below are a few examples of events or purchases that are not emergencies and therefore should be saved for separately:
- Recreational travel
- Elective procedures like dental work or plastic surgery
- Elective home repairs
- New car purchase
How much do you need?
There is no way for you to know if you will have an emergency and when, therefore we recommend you save enough cash to cover your standard of living. There are a few different ways to approach this calculation but the most common school of thought is to have either (a) 3 months of expenses for a dual-income household or (b) 6 months of expenses for a single-income household.
First let’s define what single versus dual-income households are:
So why is there a different calculation based on the number of income providers in the household? Simply, it is unlikely that both providers would lose their jobs at the same time. Therefore, with a dual-income household it is likely that one provider maintains an income and can help pay expenses if the other loses their job. That is why the recommendation is only three months of expenses for a dual-income household versus six months if you are a single-income household.
To calculate your emergency fund, simply add up all of your monthly expenses and multiply by 3 or 6 depending on whether you are a single or dual-income household.
It’s important to understand that these are guidelines and not hard and fast rules. If you have more need for cash (for example, you have an old car that is prone to having problems), you can put more in your emergency fund. Some people like to have enough cash to last for a full year.
While those are good traits to know about yourself (i.e your comfort with risk), it is important to note that cash has a very low return. While a low return ensures low risk, if you save too much for emergencies you may miss an opportunity to increase your return.
Where should I put the funds?
Unlike other savings funds, the emergency fund should not sit in your typical savings account alongside your checking account. The emergency fund, in theory, may be used only once every few years or less if you’re lucky. For this reason, it is important to ensure this money is earning as much interest as possible for a cash investment. When opening an emergency fund, be sure you are saving into a high yield savings account. You can check rates here to see what is paying the highest at the moment.
As an example, a high yield savings rate may pay 1.5%, while a standard savings rate at your large bank (like a Chase, Bank of America, or Wells Fargo) may pay .01%. Take a look at the example below to see how much you are missing out over just a 5 year period.
Starting balance: $5,000
Additions or withdrawals during the five year period: $0
While a standard savings account pays you something, it’s not nearly enough for an account you may rarely use and should hold a higher than normal balance. Check your interest rate today!
What if you don’t quite have enough?
While some might be fortunate to already have enough for their emergency fund, you may be struggling to get to your required amount. Here are a few things you can do to put your savings in overdrive!
- Cut back on unnecessary expenses: I like to make a chart of my expenses so I can focus on the easiest place to cut back.
Your “fixed” expenses typically occur on a regular cadence (such as monthly) and are the same amount each time. The variable expenses will change in value monthly and/or occur ad-hoc. The places to focus when cutting expenses are highlighted.
- Make more money: If you have the ability to pick up more hours or start a side-hustle, do it! This by far and away is the best way to save more over time, increase your income.
- Sell things you no longer need or use: Do you have any old electronics, baby gear, or furniture that you don’t need? Someone else might get better use of that so don’t be afraid to part with it and make some cash. Put that right into your emergency fund.
It’s important to get creative and work hard to build up your emergency fund so you don’t go into debt or have to stress about any emergency that might come your way. Talk to your Origin Planner if you need help creating your emergency fund.