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One of the most difficult things to bear in personal finance is when you’re meeting all of your goals and then tragedy strikes. It happens to everyone inevitably - maybe your car breaks down, you need a new roof on your house, or there’s an unexpected medical bill.
The key to getting through these situations unscathed is to prepare for them ahead of time. With a certain finance trick, you’ll be able to cover these unexpected expenses and still meet your financial goals.
In this article, you’ll learn about how emergency funds are the key to avoiding financial turmoil. By the end, you’ll understand what they are and what you need to do to get one set up.
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What is an Emergency Fund?
An emergency fund is a stockpile of cash or cash reserves earmarked for unexpected expenses. It’s purpose is to create a safety net for you in order to cover emergencies. You should set it aside in a separate account and not use it unless it’s absolutely crucial.
You can choose to deposit a lump sum of money into your emergency fund all at once. Alternatively, you can deposit a predetermined amount into it each month from your paycheck or an automatic direct deposit.
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Why Do I Need an Emergency Fund?
An emergency fund is a personal form of “insurance” that you set up for yourself. Everyone experiences an unexpected expense or tragedy in their lifetime. There’s no way around it or to prevent them from happening. The only thing you can do is prepare yourself.
Without savings, you won’t be able to cover an emergency without going into debt. Alternatively, you might have to use money that was originally marked for another purpose. So, by having an emergency fund you’re making sure that you’ll be able to meet your financial goals, even if something goes wrong.
Don’t unnecessarily put yourself into debt with the potential to pay a ton in interest charges. Your income is your biggest financial tool, so use it to your advantage.
Accounts like IRAs and 401(k)s, and even investments like CDs can have penalties for withdrawing early. So, you want to make sure that you have liquid funds available to utilize when you need it.
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How Much Do I Need?
We recommend an emergency fund of at least three to six months worth of expenses. However, the answer to this question is completely dependent on what you’re comfortable with.
If you have a stable job and no debt, you may feel secure with less of an emergency fund. But, others may sleep better at night knowing that a larger amount of money is available if need be.
As a rule of thumb, you should have at least three months worth of expenses saved when there are two working spouses or a second source of income. Alternatively, you should have at least six months worth of expenses saved if you are single or if you are the sole income earner of the family.
To calculate your monthly expenses, first add up all of your non-discretionary bills. Non-discretionary bills include those that are regular and necessary. Examples would include things like your mortgage, utilities, car payments, gas costs, insurance, and food costs for eating at home.
Essentially, these are all the expenses that you need to pay to maintain your livelihood. Anything extra should be cut out if there is a big enough emergency to make you tap into your emergency fund extensively. An example of this would be a job loss or not being able to work due to health or family reasons.
Next, you should multiply your monthly expenses by the number of months of an emergency fund you would like to have.
For instance, if the Smith family has non-discretionary expenses of $3,000 each month, they’d need to save the following:
- 3 month emergency fund: $9,000
- 6 month emergency fund: $18,000
- 9 month emergency fund: $27,000
- 1 year emergency fund: $36,000
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Where Should I Keep It?
Savings accounts at your bank are a great way to keep the money separate from your spending accounts so you’re not tempted. However, you should be mindful of what the interest rates are on the account.
Shop around for the best interest rates on a savings account. Online options like Ally and CapitalOne 360 are well-known for their quality service and above average interest rates.
Overall, the goal is to have your money invested in something that keeps up with inflation at a bare minimum. So, if a savings account doesn’t accomplish this, you can turn to money market accounts and even liquid investments at a brokerage institution. Make sure that you do your research so you don’t lose future dollars from your emergency fund.
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What Should I Use an Emergency Fund For?
An emergency fund should be used to accommodate unemployment, loss of significant assets, or other unexpected expenses. If you are deciding whether it is appropriate to tap into your emergency fund, ask yourself these three questions:
- Is it Unexpected?
- Is it Necessary?
- Is it Urgent?
It’s perfectly acceptable to use your emergency fund, but make sure that you need to. Annually recurring expenses and holiday expenses do not quality as emergencies. Remodeling your kitchen or replacing functional appliances isn’t necessary or immediate.
Here are some examples of events in which you should have no guilt in utilizing your emergency fund:
- Job layoffs - you need to pay for a roof over your head and food on the table
- A Weather event, like a hurricane, damages your property
- Your car breaks down and you need it to get to work
- You discover damage to your home that could affect your health, like mold
- Your heater and air conditioner unit breaks
- A trip to the emergency room is needed
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Start Your Emergency Fund Today and Keep Your Finances In Check
Much like you take preventions with your health, set up an emergency fund to prevent financial turmoil. It’s one of the best tricks to feeling secure and avoiding debt. Just make sure that you deposit your money somewhere safe, but also in a place that will give you enough interest to keep up with inflation. Implementing this financial hack is bound to keep you on track to reaching your financial goals, even when tragedy strikes next.