The Ultimate Guide to Saving an Emergency Fund

 in Blog / Budget
Woman and Son

Life Happens. 

It is not a matter of if an emergency comes up, but WHEN. 

When it hits the fan, you need to be ready financially. 

Because having a cash cushion is not about restriction. It is about having freedom and peace of mind. 

Removing the burden that a financial misstep can create. Maybe your car breaks down. Your house unexpectedly needs a new roof, or you lose your job. 

It does not matter the circumstance, as long as you prepare for the storms ahead. 

Do not make the mistake of lying to yourself. There will be a day when you need additional funds to protect your finances. 

We are going to talk about how you can develop a bullet proof emergency fund. An emergency fund that allows you to take on any headwind that comes your way. 

Lost your job? No big deal, you have the cash to keep you afloat while you find a new job. 

Car engines fries on the highway? You will be ready to pay for a new one in cash. 

Water heater goes out? You will have a new one the next day. 

Stop allowing your money to run you. It can ruin your entire week if you are not prepared. It is your job to take control and prepare for the unexpected. They may call it the unexpected, but you are expecting something bad to happen. It always does. 

 Your emergency fund is the first step in the right direction to financial freedom. 

What is Your Emergency Fund is For?

Computer on desk

Your emergency fund is ONLY for emergencies. I mean my pants are on fire emergencies. 

It should not be used when you want to redo your driveway with some sharp new pavers. Or on a vacation to Tahiti with that new couple you met at Wednesday night bingo.

And for the love of God, it is not to be used so you can get some new rims for the whip (that’s a car for you old folks).  

You need to reserve your emergency fund for truly unexpected expenses that you can not cover. This can be any of these things and much more: 

  • Job Loss 
  • Unexpected medical Bills 
  • Car Trouble 
  • Necessary Home Repair 
  • Business Loss 
  • Debt (yes that is an emergency) 
  • Or any other problem that arises that you can not cover with cash. 

What Does The Emergency Fund Need to Cover? 

Coffe and breakfast on the table

There are two camps when it comes to the emergency fund. 

Those Who Just Want to Save for the Bare Necessities

Some people call these The Four Walls. These are the people who want their emergency fund to cover the basic needs in the event that they get fired. Usually rent/mortgage, food, transportation, and utilities. They believe they can cut back and get by on everything else. 

The pros of this option are that you do not have to hoard as much cash. This allows you to plow more money into investments for your future. 

Those Who Want to Maintain their Lifestyle 

Kimmy doesn’t want to give up her weekly brunch with her pals. Johnny wants to be able to buy the latest video game when he wants. Clyde wants to still drink FIJI water because it kind’ve tastes a little different, okay?! 

Hey, no judgement here. You do your thing. 

But prepare for it.

You will have to save more funds to make sure you have the runway to be able to maintain your lifestyle. That’s the power of having additional cash saved, you can still live your life the way you want to, without stress or anxiety. 

You want to pick which side you feel most comfortable with and take action. 

Figure out How Much You Spend Each Month

If you don’t already have a budget, you will need to figure out how much you spend each month. First, calculate the bare necessities. That would be food, rent/mortgage, transportation, and utilities. This will be your first target number. 

Next, figure out how much you spend on all other expenses. This can be clothes, alcohol, eating out, manicures. You name it. This will be your next target. 

Finally, think about how much runway you need if you lost your job. Could you find a job in 3 months? Maybe, but you will be taking a slight risk. Can you find a job in 6 months?

Most people can, which is why this is the typical personal finance recommendation.

You need to pick a timeframe that makes you feel comfortable. If you still can’t decide, follow the phases below until you feel comfortable.  

The Phases of an Emergency Fund 

camera and succulant

Personal finance is by the very definition, personal (thanks captain obvious). The amount of money you stash away in your emergency fund is going to depend on your needs.

That is why I lay out the phases on an emergency fund. This will allow you to choose how much cheddar you will need to stash away.

As you will see later in this article, you will also have freedom in how you can save your emergency fund based on how much cushion you have using The Emergency Fund Ladder. 

Phase 1: Your First $1,000

Dave Ramsey is famous for creating personal finance “Baby Steps” in his book “The Total Money Makeover”. The first baby step to get control of your money is to save $1,000. For some, this may be hard, and others can do this quickly. 

It does not matter what boat you are in, in order to protect your finances from unexpected expenses, you need to have your first $1,000 stashed away as your first line of defense. This will give you some breathing room to start building up your reserves.  

If you struggle to save money, begin automating your savings now. Every time you get paid, have money automatically transferred to your emergency fund. This way you can’t blow it on silly purchases that bring zero value to your life. 

Phase 2: One Month Of Expenses 

Once you save your first $1,000, it is time to build up your emergency fund to protect you against a temporary furlough. You want to build up to one month of expenses. 

Getting one month ahead in your finances is what everyone should strive to do. The reason behind it is that you will be able to pay this month’s bills with last month’s paycheck. It is a stress-free point to be in your day to day life. You worry less about what your money needs to do immediately. 

One month of expenses can feel like a daunting hill to climb. But hey, you just saved your first $1,000. You can do this. It may take a little time and that is ok. You just need to make progress. 

Phase 3: 3 Months of Expenses 

Guy looking at camera low angle

Now you are ready for the emergency and fund big leagues. The purists will argue that this should be the minimum amount you save. I will echo this until I turn blue in the face. Save the amount that makes you comfortable. 

3 months of expenses is a great place to be. If you lose your job, it will allow you 12 weeks to find another job (or at least earn a part time income in the meantime). This may take you some time to achieve. 

For example, if you spend $5,000 a month to live, you will need to accumulate $15,000 in your emergency fund. When you are trying to invest, save, pay down debt, and pay bills, that is not an easy milestone. 

The way to get to this step is progress incrementally. You already saved enough money to cover one month of expenses. You can get to 3 months as well. 

Phase 4: 6 Months of Expenses 

Saving 6 months of expenses in your emergency fund will protect you from any job loss that can occur. This allows you to have half a year to find another gig. While allowing ample time to pick up part-time work in between jobs if needed. 

6 months of expenses eliminate any anxiety most people have. This can take a few years to build up. In that time you will most likely have setbacks because you will need to use your emergency fund for other emergencies (Life, am I right?). But, if you keep plugging away, you will eventually have six months stashed. 

Phase 5: 9 Months of Expenses 

Saving 9 months of expenses is no small feat. At this stage, you will be able to handle any job loss and take on a number of other issues life throws your way. Saving 9 months of expenses is usually a stepping stone for someone who wants to get to save up a year’s expenses. 

Maybe you feel more comfortable if you lost your job. This would allow you close to a years time to find a new job or give you a short runway to see if you can get a small business up and running.

Phase 6: 1 Year of Expenses 

Having 1 years worth of expenses gives you options. You now are able to see if that side-hustle you have been working so hard towards would work if you went full time. You could take a year sabbatical. Or, give yourself a massive safety net for retirement.

The freedom you have is endless. The stress of money should melt away for anyone who was uncomfortable during the other phases. You have finally saved enough cash for anything that life can throw in your direction. 

Phase 7: 2 Years of Expenses 

Two years!? Why would anyone save two years of expenses?

I hear you 3-month emergency fund truthers. The two years of expenses crowd has a purpose for doing so.

It could be to give you more runway to start a business, provide more cushion before you leap into the unknown of retirement, or let you mind rest knowing there is almost no problem your emergency fund can’t fix in the short term. 

I like the idea of having two years of expenses saved for some retirees. The main reason is they will in fact lose their paycheck. This gives an increased cushion if for some reason retirement isn’t all they thought it would be. 

My Emergency Categories 

Persona on tablet

I have a fairly specific emergency fund strategy. I actually break out what could happen into categories on YNAB. You do not have to have your emergency fund set up this way. You can just chuck money into a savings account every month and pool all your emergencies into one account. 

Do what feels right. You do you my friend. 

Let’s get into my categories, shall we? (Raises Monocles) 

Job Loss 

The job loss category is there to terminate (nice choice of words there) any risk of getting fired, furloughed, or quitting because we are tired of doing TPS reports over the weekend again. 

Shout out to office space. 

Thankfully, we have never had to use this category. Once we reached our goal of 6 months of expenses, we decided to add more very slowly. 

Since we have a dual income, 6 months of expenses is more than enough cushion.

It’s most likely overkill to save that much on dual income. 

But, we wanted to sleep soundly at night. The odds of both of us losing our jobs at the same time would be slim to none, but if it’s possible, I’m going to hedge against that risk. 

Car Repair 

We have a separate category for car repair. I throw $200 a month in this category to just get it up and running. 

This fund gets used a few times a year. I used to have a car maintenance category as well but just combined them. 

$2,400 a year covers oil changes, general maintenance, and leaves enough extra to build up if the engine blew up. 

A few years back we had a transmission go that cost $3,000. We didn’t sweat it, the cash was in our car repair fund. We didn’t have to think about it twice. 

Medical 

For medical we have a specific strategy. We get health insurance via our employers and save enough each month to cover the max deductible our plan has. Anything left over gets rolled into an HSA each year. 

This allows us to invest out money in a tax advantaged account for medical expenses for our future. 

It never hurts to have a pile of money for medical expenses in your golden years. 

 

Home Repair 

Home repair is only  necessary if you own a home. If you rent, then your landlord will take care of this for you. 

I throw a few hundred bucks at this category as well. Home repair always seems to live up to the old saying “when it rains it pours”. This category seems to build up every few years then Kaboom, everything seems to break at the same time. 

If you own house, am I right or am I right? 

I’ve drawn this category down to almost zero a number of times. It is essential for us. 

Emergency Fund 

Believe it or not, after all that, I do have a category called emergency fund. This category has yet to be touched. I don’t know why I have it still to be honest. All the other categories cover emergencies, but here we are. Still plowing money into that fund every month.

I don’t have a specific reason for it other than. 

If this fund grows too much over the years I may stop contributing to it and spend that money elsewhere. 

Where to Keep Your Emergency Fund

Should I keep my emergency fund invested? Should I keep it under my mattress? Is Bitcoin a good place for my emergency fund? 

The answer to all these is a resounding NO. 

You want your emergency fund to be easy to access. If an emergency arises, you don’t want to have to sell stocks to be able to get your money.  

You need your emergency fund to have DRIP. That means you need it to be liquid (or available). I was just trying to make it cool for all you hip readers.   

There are in fact a few places I would recommend. 

Good Old Fashioned Savings Account

Your savings account allows easy access to this money. I would consider unlinking your emergency fund savings account and your checking if you tend to be, dare I say, “spendy”. You know who you are. 

High Interest Online Savings Account

If you are going to have cash laying around, why not let it work a little for you. A high interest savings account is the best place to keep your emergency fund. It can be easily accessed when needed, and still allows your money to earn a little interest. You traditional bank may offer .05% where many high yield online savings accounts will offer 1.5% – 2% interest to you. 

That may sound like a small number but can amount to thousands of dollars depending on how much you have in your emergency fund. Why not collect free money? 

Money Market Account

A money market account is similar to High Interest Savings Accounts. They typically will pay an even higher interest rate. This is where I park my emergency fund. Money Market accounts will pay anywhere from 1.5% – 2.5% interest rate. This allows you to collect interest each month on your money. 

To give you an idea of what that interest equates to, I opened my first Money Market Account at 2.1% with $10,000. That 10K was earning just over $60 a month in interest. As you build up your account, this will amount to a few thousand dollars per year. 

Cash

Keeping a large emergency fund in physical cash is not recommended. Mainly because you have increased risk when you have cash in your house. What if your emergency is your house catching on fire or flooding? 

If you feel comfortable having some of your emergency fund in cash then that’s fine.  Just don’t store 10K under your mattress unless it is the only way you can sleep at night. 

The Emergency Fund Ladder 

There is another way you can structure the emergency fund that would allow you to earn some extra interest on your money. 

Let’s face it. 

Hoarding large chunks of cash is not the best way to get a return on your money. 

Enter The Emergency Fund Ladder 

This is a strategy that allows you to earn some additional interest through CDs and bonds. 

Let’s say you want to have one years of expenses saved for retirement. 

Here’s what it would look like: 

  • 3 months of expenses in a high yield savings account. 1.6% 
  • Next 3 months of expenses in a 3 month CD 1.8% 
  • Next 3 months of expenses in a 6 month CD 2% 
  • 3 months of expenses in a 9 month CD 2.2% 
  • Final 3 months of expenses in a one year bond or CD. 2.5% 

There are downsides to this strategy. First, there are times where CD rates are lower than plain old high interest online checking accounts. 

Obviously if that is the case, do not utilize this strategy. 

Secondly, if you need more money for a major emergency, it is tied up in an asset that has not matured yet. 

Finally, it’s more work for minute percentages. 

Who is this strategy for? 

Anyone who wants to get the maximum safe return on their money without shoving your emergency fund into the ebbs and flows of stocks. 

Should I Keep My Emergency Fund in Stocks?

Stocks are one of the best places to keep your money when you are not interested in touching it for 5-10 years. 

What stocks are not good for is short term savings. This includes savings like down payments, vacations, or emergencies 

Stocks are known as assets that are not particularly liquid. Meaning you won’t have access to your money right away. 

Say, you invested your emergency fund in the stocks market because you wanted the best return. 

You add $25,000 into a brokerage account as your emergency fund. You invest in something diversified like an index fund. 

Then one day the market takes a dive and the economy enters a recession (yikes). 

This causes your company to cut jobs. You get fired. 

Now that $25,000 emergency fund that was supposed to last you 5 months has fallen to $12,500. You have much less time to find a new job. 

And, in a recession that becomes a problem. 

This example may be drastic but it is a very real possibility if you keep your entire emergency fund it stocks. 

You are risking the possibility of your emergency fund getting cut in half, just when you need it most. 

My advice, just don’t do it. 

The Case Against The Emergency Fund (For Some)

There are some folks who can consider not having an emergency fund.

That would be those who are part of the FIRE (Financially Independent Retire Early) movement or the FI community. 

The FI community usually has accumulated a large sum of money through a large savings rate.

Because they already have a big chunk of change, they have the opportunity to hedge their bets if they want to roll the dice with no emergency fund. 

Here’s why. 

They Already Don’t Have a Paycheck 

First of all, most financially independent folks already live without a paycheck. Because, well, they are retired. 

They don’t have to rely on a job to sustain their lifestyle. Their big pile of cash produces the income they need to support the life they want to live. 

The biggest concern people have when they build up a big emergency fund is they are hedging against job loss. 

This is not a problem for the average Financially Independent individual. 

Credit Card Float – 30 Days of Cushion

In order to become financially independent, you have to be responsible with your personal finances. You would not be able to accumulate enough wealth to cover your living expenses. 

This is why I’m comfortable making this argument. 

If something drastic happens, the FI community could use their credit card as a 30 day emergency fund. 

Let’s say your car breaks down and it needs $2,000 to repair the engine. 

You don’t want to draw down on your portfolio just to pay for a car, so you throw it on a credit card. 

Now you have 30 days to come up with the money and pay off that card. 

It gives you 30 days to come up with a plan. If you have ever met a person who is FIRE, they are always resourceful. 

Brokerage Accounts

If the money can’t be made up in 30 days, you can use your brokerage accounts. Everyone in the FI community has their life savings invested, and they live off that money (usually with a 4% drawdown each year). 

This means that they can draw down on this pile of money if an emergency happens. This creates a massive safety net. 

HELOC – Low interest Loan 

If you have a home, you have another option. 

A HELOC or home equity line of credit is that option for those who have achieved FI. This is where you borrow money against your house.

HELOC’s usually have a low-interest rate. People use them for a number of things, including renovating their house. 

Final Thoughts 

For the majority of us, an emergency fund is necessary to hedge against the risks life throws at you. 

The key is to save the amount that makes you comfortable, stress-free, and without anxiety. 

andrew
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