I once read that nearly half of Americans don’t have $500 saved to cover an unexpected expense. Back then, I was part of that statistic and felt the stress that came along with being financially unprepared. Today, I’ve made it a mission to stress the importance of having money saved for rainy days, emergencies, and unexpected job loss.
What is an emergency fund?
An emergency fund is a savings account used to cover emergencies. The term emergency is quite financially vague with people associating it with either having a flat tire or losing income. But all agree that an emergency doesn’t include new clothes, gifts or night out with friends.
I define an emergency fund as a savings account used specifically to cover periods of underemployment or unemployment. It’s an emergency when your income stops. Without a source of income, you may find yourself unable to pay for rent, food, and utilities. That is a state of personal emergency.
However, I’ve learned how helpful it is to have 2 savings dedicated to unexpected situations. The two types of emergency savings are the rainy day fund and the opportunity fund.
The first is a rainy day fund.
A rainy day fund is exactly how it sounds. It’s used for rainy days which are moments like a flat tire or an unexpected medical bill. I recommend having at least $500 in a rainy day fund or the amount of your auto insurance deductible. I use to keep $1,000 in my rainy day fund to cover, at the minimum, my deductible. In the event my main mode of transportation to my income paying job needed work, I had peace of mind knowing I had my deductible covered.
The second is the opportunity fund.
The opportunity fund is just a better way to think about the time when you unexpectedly lose your job, hours are reduced, or you’re hospitalized. I recommend at least 6 months of basic living expenses saved to support you during a “no income” emergency. I call it an opportunity fund because you regain back the time you once spent at work to explore new job opportunities with little stress.
Now, once you’ve tapped into your rainy day or opportunity fund, you must replenish what you’ve used. And I also suggest reviewing your finances once a year and increasing the amount as necessary.
How to save in an emergency fund
You can set up two savings accounts with your current financial institution or find an online bank. Title or name these emergency fund accounts accordingly with the target amount. I find naming them “$500 Rainy Day Fund” or “$12,000 Opportunity Fund” helps me save and not withdraw money for unrelated needs.
Set up automatic transfers to help you save each pay period. And find ways to earn extra cash through side gigs as well as using any unexpected income, gift money, tax refunds or bonuses to fund these accounts.
Should you have this money earning interest? Ideally, your money should be easily accessible and liquid meaning it’s cash or can easily be turned into cash, and in an interest-bearing account. I currently have my Rainy Day Fund with my credit union and my Opportunity Fund in multiple certificates using a CD ladder strategy of 1-36 months.
Why Emergency Savings Funds Matter
1. You Can Avoid Credit Card Debt
Unexpected expenses are going to happen. It’s not a question of if, but when. And unfortunately, if you don’t have an emergency fund, the only alternative might be using a credit card.
Using credit isn’t a terrible backup plan if you can afford to pay off charges every month. But if you can’t, building an emergency fund is the best way to prepare in advance and avoid a ton of interest.
Going forward, always pay yourself first. Reduce how much you spend on shopping or entertainment and you’ll slowly free up cash to increase your savings.
2. You Won’t Have to Borrow from a Retirement Account
If you have a 401(k) plan through your work or an individual retirement account, don’t think of these accounts as an emergency fund. Taking early withdrawals from a retirement account is costly. There’s a penalty and you’ll pay interest on any withdrawal. Of course, if you don’t have an emergency fund, tapping this account might be the only way to get cash. Unfortunately, the more you take from a retirement account, the less income in retirement impacting your ability to retire well.
3. You Don’t Have to Get a Costly Payday Loan
Payday loans and title loans are costly and risky, but if your back is up against the wall and you need fast cash, these loans may seem like a doable option since they don’t involve credit checks. But you’ll receive an interest rate that’s higher than most traditional loans, and with title loans, there’s the risk of losing your car if you default. With an emergency fund, you don’t have to rely on expensive alternative lending to get through a tough time.
4. You Can Avoid Late Fees
If you use money allocated for bill payments to cover an unexpected expense, there’s a greater chance that you won’t have the cash to cover your monthly expenses and get hit with late fees and penalties. These fees can be between $10 and $45 depending on the provider or creditor. And if you’re unable to pay a bill altogether, and you’re more than 30 days late, your creditor might report the delinquency to the credit bureaus which can lower your credit score.
5. You Can Maintain Your Dignity
There’s no reason to feel embarrassed if you need financial help. But understandably, you want to keep friends and family out of your personal business. If you don’t have an emergency fund and you’re running out of options, borrowing cash might be the only option available to you.
Going to family or friends for financial help can be awkward, and if you’re unable to repay the money, this can drive a wedge or create tension in the relationship. All of this can be avoided with an emergency fund.
6. You Don’t Have to Sell Your Stuff
In the past year, I’ve seen two people go through financial hardship and they had to take extreme measures to keep their heads above water. In both cases, a job loss triggered financial hardship, and to keep creditors happy, they sold as much personal stuff as possible to generate income. This included their second car, electronics, furniture, and jewelry. They did what was necessary to endure the trial, and although each person made it through this tough period, the scars remain.
I say all of this to impress the importance of an emergency fund because in both cases these individuals didn’t have any type of “real” savings. Unemployment compensation didn’t compare to their previous earnings, so when the rent/mortgage was due, unloading personal belongings for cash was the only way to keep a roof over their head.
7. You Can Avoid High-Interest Financing
An emergency fund is especially important if you’re a homeowner. Unlike a renter, you’re responsible for repairs and maintenance to your property. And unfortunately, some repairs might require immediate attention, such as a major roof leak, a broken window or a broken HVAC system in the middle of summer. If you don’t have any emergency savings for these expenses, some repair companies offer in-house financing, and sometimes you can qualify regardless of credit history. The problem, however, is that this type of financing has a much higher interest rate than those offered by banks and credit unions.
8. Peace of Mind
Peace of mind is one of the surprising benefits of having an emergency fund. Knowing you have a cash reserve can ease some of your financial worries. Nobody wants an emergency to happen, but if one occurs, you’re prepared to handle most expenses thrown your way. You can avoid a lot of panic, headaches and sleepless nights since you don’t have to worry about how you’ll drum up cash for life’s curveballs.
Have any other reason why emergency funds matter?