According to a 2015 report by the Federal Reserve on the economic well-being of American households, nearly half of Americans would have trouble finding $400 in the case of an emergency.
Think about that.
$400 is pennies compared to the multi-thousand dollar medical bills, car repairs and other emergencies Americans face on a regular basis. As a country we’re not just unprepared for crisis – we’re practically asking for it.
And what’s more, not being able to cover a $400 emergency expense costs money of its own. If you have to take out a loan or use your credit card, you’ll be paying exorbitant interest rates – not to mention any late fees or penalties you may incur if you don’t address the emergency fast enough. In other words, being unprepared is expensive.
But all it takes to avoid financial catastrophe is a little persistence. If you sock away even a minimal percentage of your income for a short period of time, you’ll be infinitely more prepared for anything that comes your way. It’s not about being rich or poor – it’s about living within your means.
If you’re still not convinced, here are a few reasons why you need an emergency fund – and what you might need to use it for.
Why you need an emergency fund
When people don’t have the cash to pay for an emergency, they typically have to pay for it with a credit card, payday loan or other form of debt. Unfortunately, emergencies don’t go away just because we can’t afford them.
By paying for something in cash you eliminate any interest fees or other costs. For example, if your car needs new tires that cost $600, you’ll pay $836 total if you use a credit card with 15% APR and only make minimum payments. That’s $236 you’ll pay in interest. If you have an emergency fund, you can pay with cash and save yourself hundreds.
“An emergency fund is necessary to fund any little hiccups that occur in your life, such as a major automobile repair, medical expense or even being laid off from your job,” said David G. Niggel, CFP® at Key Wealth Partners. “If you do not have an adequate emergency fund, you will have to borrow money or use high interest rate credit cards. This will hurt your financial future.”
How much you should save
The standard is to have three to six month’s worth of expenses just in case. If you’re self-employed or work in a volatile field, you might want to have between nine months and a year’s worth of expenses.
Remember, there’s a difference between expenses and income. Add up all your fixed expenses like insurance and rent, as well as variable costs like groceries and gas. Include a little leeway for unexpected things. Then, multiply that figure by how many months you want to save for.
Where to store it
If you have a fully funded emergency fund, you probably have at least several thousand dollars in your bank account. Some people hate the idea of storing so much cash in a checking or savings account, where you’ll only earn 1.05% APY on your money.
But don’t be tempted into investing your emergency fund, as much as it hurts to watch it sit. Your emergency fund needs to be liquid, meaning you need to be able to access it anytime the need arises. If it’s in a CD that doesn’t mature for another year, you’ll pay an early withdrawal penalty.
Some people also try to invest their emergency fund in the stock market, but market volatility makes this a risk not worth taking. If the market goes down at the same time you need to access your money, you might find that you have less than you started with – maybe less than you need to cover the emergency.
The best place to store your emergency fund is a high yield savings account, preferably earning 1% interest or more. You can withdraw from a savings account easily and have your money in 2-3 days. Local credit unions sometimes have higher interest rates than big national banks. You can look through Kasasa to see which ones you’re eligible for. Don’t expect your emergency fund to grow as much as it would if it were invested, but rest assured that it’ll be safe.
According to the Bureau of Labor Statistics, 49% of unemployed workers spent more than 15 weeks without a job. About 30% had to wait more than 27 weeks, or roughly six months, before they found work again.
No matter how steady your employer or how viable your industry is, you need to have an emergency fund to prepare for those times when you get, laid off or fired or have to take a leave of absence. Unemployment is one of the most stressful situations for most people, so you really don’t want to compound that stress by adding financial uncertainty.
An emergency fund can also be a lifeline if you want to quit your job, but don’t have a back-up plan. Even if you just want to take a sabbatical and ponder your future, it’s empowering to know you have the wherewithal to pick up and leave whenever you feel like it.
So how much should you save in case you lose your job? Think about how long it took you to find the current gig. If you barely got your unemployment check before you were signing a new W2, then a couple month’s of expenses is fine. But also keep in mind that the more you advance, the fewer positions there may be. If you have a high salary, it can take a long time to find a company that’s willing to pay you your old rate.
If you have loved ones living across the country, you’ve probably faced the dilemma of what to do when there’s a death in the family and a funeral far away. Can you afford to take time off work and travel? Will your pets and plants be taken care of?
An emergency fund could allow you to afford the flight, hotel and other related expenses. You can also use it if a relative lands in the hospital or if you want to be with a friend during her time of need. Remember to ask for a bereavement discount when you book your flight.
To gauge how much you need, make a list of the cities where your closest family and friends live and where you’d be willing to travel to if something happened. Then, look up last-minute flights from your destination to theirs. Flight prices change frequently so add an extra $200 to your estimate, which will be enough in case there’s a funeral during a major holiday weekend.
Then, consider if you’d be able to stay with family members locally or if you’d want to get your own hotel room. Again, do some research around the area to determine the average hotel stay. You can also look at Airbnb, which might be cheaper.
Homeowners should be especially conscious of having an emergency fund sufficient for any home repairs. The standard rule of thumb is to save 1% of the purchase price each year. For example, if your home costs $200,000, you should save $2,000 each year. If you don’t use it, the funds can continue to accrue until the day comes that you need a new roof or AC unit.
Some repairs and maintenance work can be put off until later, but emergencies happen. Even if you have homeowner’s insurance to cover something like a break-in or flooding, you’ll have to pay the deductible upfront which usually costs between $500 and a few thousand dollars. Plus, you might have to pay for some expenses upfront before your insurance will reimburse your claim. This is especially important to have before you buy a house. Just because you’ve only owned your home a week doesn’t mean the fridge can’t break during that time. Once you sign the mortgage, you’re mostly on the hook for any repairs.
Some people choose to have a home equity line of credit (HELOC) open for this very reason. A HELOC gives you access to a certain amount of money that you can use for any reason. You can use as much or as little of the HELOC as you want. If you already have a HELOC when the water heater breaks, then you won’t have to worry about scrounging up the cash to pay for it.
A HELOC only really works if you have enough equity in the home for the bank to loan you money. For example, if you only have 10% equity in a $200,000 home and the bank lets you borrow 80% of that equity, then you’ll only have access to $16,000. Keep that in mind when you’re adding up how much of an emergency fund you really have.