I previously shared that it’s more important for parents to have an emergency fund in place, pay off debt, and save for their own retirement before thinking about saving for college. It’s the same advice when flight attendants tell you to put on your own oxygen mask before taking care of others.
An emergency fund is money set aside to cover the unexpected: the cost of trips to the emergency room, vet bills, major car or house repairs, or living expenses while looking for a new job. If you’re a freelancer or entrepreneur, your emergency fund may also cover slow periods when you’re working less and therefore earning less. Or if you’re starting a new business, an ample emergency fund can cover the income gap while getting your business off the ground.
A December 2015 survey by Bankrate.com found that about 63 percent of Americans say they’re unable to handle an unexpected expense like a major car repair or emergency room bill of around $1,000. Do you have enough in savings in case a you’re surprised by a big bill? And even if you have the appropriate health, renter’s or homeowner’s, car, and disability insurance to cover certain unexpected expenses, you still want to have enough in savings to cover any deductibles.
One rule of thumb is to save 3 to 6 months of living expenses, but several factors impact the amount you may need in your emergency fund:
- How many people depend on your income? The more people relying on your income, the more you’ll want to save, particularly if you’re in a single-income household.
- How variable is your income? If you’re a freelancer, you may want to save 6 to 12 months of living expenses to cover slow periods, as well as the unexpected.
- How stable is your job? Do you work in an industry or city where it’s easy to find a new one?
- If you were to be laid off, are you eligible to receive severance pay?
- Do you have other revenue streams, like a side business, you can rely on?
- What’s your risk tolerance? In other words, how much money do you need to have set aside to feel comfortable?
Where to Keep Your Emergency Fund
As for where to keep your emergency fund, you want the money to be somewhere liquid, accessible, and safe. It’s good to keep at least a portion of it in a checking or savings account so you can access the funds immediately. Then, I like to keep a portion in an online savings account like Ally Bank or CapitalOne 360. The returns are slightly better than a traditional brick-and-mortar savings account, but you usually have to wait a few days for the money to transfer to your external checking account. To minimize the risk, make sure your checking or savings account (up to $250,000 per depositor) is insured by the FDIC.
For a safety net to cover longer term situations like a job loss or medical condition, you can keep a portion in an online savings account and then invest a portion in a low- to moderate-risk brokerage account. While a savings account is safe, they’re not truly risk-free since current interest rates are below 1% and you’ll most likely be losing money over time to inflation. Investing in an online brokerage account like Betterment or Vanguard will offer better returns while still being fairly accessible. Electronic withdrawals to your bank generally take 4-5 business days due to the required sale and settlement of securities. And fingers crossed you won’t need to tap into your longer term safety net!
If saving 3 to 6 months of living expenses seems daunting, work towards saving one month of expenses. Then create monthly automatic transfers to your emergency fund until you reach 3 to 6 months of living expenses. If your income varies, allocate your savings based on percentages instead of dollar amounts. For example, make it a goal to set aside 5% of every client payment for your emergency fund. This will automatically help you save more dollars when your income is higher and keep you from overextending yourself during leaner months. Or if you can super charge your savings by depositing a portion of your tax refund or annual bonus into your emergency fund.
Once your emergency fund is in place, then you can start thinking about eliminating debt, saving for retirement, and saving for other personal goals (i.e. buying a house or traveling).