Hi guys! Let’s spend a little more time talking about emergency funds. I have to admit, I wasn’t clear on what an emergency fund was until just a few years ago. I had a savings account and I knew that it was important to set money aside, but I wasn’t assigning any real roles or purpose to my account. Believe it or not, an emergency fund and a savings account are not the same thing.
Here’s my take on it. A savings account is an account that you can set up at a bank or credit union that pays you a small amount of interest every month for keeping your money there and has limitations on the number of withdrawals you can make in one month. A savings account is a generally safe and reliable way to set aside money for short-term goals. So, you can use your savings account for any purpose you want. I have a savings account that I use to cash-flow gifts for birthdays and Christmas. I go into more detail on that in a blog post here. The money that I set aside for emergencies, however, is treated a little differently and considered a different fund than a rainy day or sinking fund.
First, let’s think about what the ’emergency’ is behind the emergency fund. What qualifies as an emergency? We need to define the boundaries. An emergency fund is different from a regular savings account because we aren’t just trying to limit the number of times in a month that we can dip into the money. We’re are trying not to touch this money AT ALL unless there is an emergency or a large expense comes up that is tied to a necessity or a four wall – more on that in a second. That being said, an emergency is not getting that new dress or putting new rims on the car or getting mom and dad that thing they’ve been wanting for years. An emergency or four wall necessity is something like a major car repair or major home repair like (what I actually have to do tomorrow) replacing an old HVAC system that no longer functions. And, of course, an emergency is the loss of your job or other type of reduction in income that leaves you without the ability to pay for your monthly needs.
So, how much money do you need to set aside in an emergency fund? First, you need to understand your monthly expenses. Remember when I asked you to track your expenses for 3 months? That’s exactly what I did. I took a look at how much I spent every month to take care of all of my bills, pay the mortgage, buy groceries, etc. and took an average. This is what I know I need to be bringing in to take care of one month’s worth of total expenses. This is going to be the basis for the amount of money that you should be setting aside. Now, some people will say that you only need to look at your four walls which are utilities, transportation, food and shelter and not to include ‘fun money’ for entertainment or subscription services or things of that nature. That is totally fine, and for a lot of people it’s more feasible and makes more sense to approach it that way – building an emergency fund that covers just what’s needed to pay for these basics and nothing more. To think about all of this in real terms, if you were to lose your family’s source of income and nothing at all was coming in, you are going to be much more concerned about having enough money to pay the rent or the mortgage and buy food than you are about keeping that Netflix or Disney+ subscription. Those non-necessary expenses go out the window until you’re able to get back on your feet financially. So, the rule of thumb for an emergency fund is to save the equivalent of X-months’ worth of four wall expenses.
I completely agree with this line of thinking. If, God forbid, anything was to happen to my job, I’m cutting out anything that’s not a necessity but had been costing me money. So, the primary focus is setting aside enough money to cover the four walls. However, for me personally, as a single mom on one income, I prefer to set aside enough money equivalent to my total monthly expenses – Netflix subscription and all. I like the added peace of mind that comes from having my four walls taken care of plus a little extra buffer. Now, if I were to lose my job, am I keeping my Netflix subscription? NO! But, I like to stay prepared for as many scenarios as I can. Take this past winter for example. My electric bill went up over 60% due to changes in the company’s rates and in my usage (started running the heater when it got cold). Last year, my water bill also increased a little bit due to a new public service tax from the city. So, it’s peace of mind for me knowing that if those bills come in a higher than average for whatever reason, I have some buffer saved to cover that fluctuation even if I’ve lost my income. Again, I like to stay prepared.
So, no matter how you do it, how much do you need to save exactly? I’ve seen agreement from several financial experts that say, in general, an emergency fund should have a minimum of three months’ worth of expenses. If you’re single or if you’re married but have only one source of income for your family, you should aim to save six months’ worth of expenses. I’ve already told you guys that I prefer to have buffer for added peace of mind, so even though I’m single, I had about seven months’ of expenses saved with a goal of setting aside nine months to one years’ worth. (Did I mention that I like to stay prepared?) The breakdown of my HVAC means I took a bit of a hit, but the good news is, that’s exactly what my emergency fund is for! I already had the money set aside, so I’m able to pay the total cost for the replacement upfront and do not have to take out a loan or set up any type financing with the HVAC company. And money talks! A lot of companies will offer you a discount if you’re able to pay the total cost upfront. (Side note – if they don’t automatically offer it to you, ask them about it. Remember, it’s YOUR money. Speak up!) In this case, the company I’m working with is taking about $300 off the total price just because I’m paying with a check. I would not have gotten this discount if I had setup an installment plan, gotten financing or paid with a credit card – another perk of having a fully-funded emergency fund. Now, I’ll just need to double-down on saving until I can build my emergency fund back up. Don’t forget that this is part of the puzzle too. If you need to take money out of your emergency fund, be sure to put it all back as soon as you can.
The last thing I’ll mention is that I recommend you take some time to look at where to put your emergency fund. You could put it in a regular savings account, a money market account or a high-yield savings account. I’m no expert when it comes to the nitty-gritty details of the differences between these three, but here’s the gist:
- A savings account is an account that normally does not have a linked debit card or checks and pays a low interest rate.
- A money market account is an account that can have a linked debit card or checks and in some cases will pay more interest than a traditional savings account. This account is highly recommended for emergency funds since the check capability makes the funds more easily accessible in an emergency.
- A high-yield or high-interest savings account is an account that normally does not have a linked debit card or checks but can offer a much higher interest rate than traditional savings or money market accounts since they do not have the costs associated with maintaining physical branches and pass those savings on to customers. They are essentially online savings accounts at an online bank that you link to a checking account that you have with another bank.
Do your research and make sure you understand the ins and outs of each option for yourself before you make your decision. I decided that the high-interest savings account at an online bank would work the best for me. I will note that the interest rate with this option is variable and does fluctuate with the federal funds rate. My interest rate decreased throughout 2020, but it still remains significantly higher than the rate that I get with the savings account that I have at a traditional banks for a sinking fund. Whichever account type you pick though, make sure that the institution your account is with is FDIC insured so that your money is protected against loss if the bank, savings association or credit union goes out of business or fails for whatever reason.
So, what strategy will work the best for you and your family? Will you set aside the equivalent of your monthly four walls or your total monthly expenses? Will you use a traditional savings account or something else? There are no wrong answers to these questions. The important thing is to save, save, save until your emergency fund is fully funded. Less reliance on loans and credit companies and more self-sustainability is always the goal. You build wealth when you’re not constantly owing somebody else.