One of the trickiest personal finance questions to answer relates to whether it makes more sense to pay off debt or save. While paying off debt is often the better choice, something that should take priority in this circumstance is creating an emergency fund.
Having money set aside makes it possible for us to weather financial emergencies without going into more debt. Unplanned expenses often arise at the worst time, but knowing you have some money set aside for emergencies can make the experience less stressful. Having an emergency account means you can stay on track for meeting major financial goals even when you’re faced with unexpected expenses.
The Basics of Creating an Emergency Fund
As the name implies, an emergency fund is a cash reserve that helps you deal with unplanned expenses like home repairs, medical bills, car maintenance, or even loss of income. Without this sort of account, you may need to dip into other savings or, worse, go into debt to cover the unexpected expenses.
Taking out a loan or putting these expenses on a credit card makes it more expensive in the long run as you will need to pay interest, which can put you even further behind with your financial goals. When it comes to creating an emergency fund, the question that many people have is how much they need in the account. The answer to this question is different for everyone.
You can start by reviewing the unexpected expenses that have arisen in the past to figure out how much you might need. However, it is also important to think about your overall income and your ability to pay the account back if you use it. While it may sound paradoxical, having more money in the account provides more of a cushion if your income is low or varies. With this approach, you give yourself more time to pay back the amount you needed.
Paying into a fund when the budget is already tight may seem impossible, but even putting a little aside each month adds up quickly. Another strategy is thinking about you monthly expenses and saving for six months’ worth of living costs. Then, if you lose your job, you have a good cushion to keep you afloat as you look for other opportunities.
What Kind of Account to Use for an Emergency Fund
Choosing how to store your emergency fund is another important question to answer. You may be tempted to invest the money so that it can grow while it goes untouched, but this can actually be problematic. Because of the nature of this fund, you may need quick access to it, and invested money does not typically have the liquidity to make it feasible. Also, you may find yourself forced to sell investments when they are down if you do not have the time to wait out a market recovery.
A better option is choosing a savings account with a high interest rate. Emergencies can happen at any time and a savings account gives you immediate access. Importantly, you should create a separate account from the one you use daily so that there is some barrier to dipping into the reserve.
Putting the money in a savings account can allow it to earn some interest, even if the returns are much less than if you invested it. You do have some other options when it comes to saving an emergency fund, but they all have fairly significant drawbacks.
For example, you could keep the money in cash, but then you leave yourself open to loss or theft. Another option is putting the money on a prepaid card, but this also leaves you open to loss or theft. Moreover, it could be tempting to use the card for situations that are not emergencies. In general, a savings account is the best option for storing this money and keeping it safe.
Strategies for Saving Money in an Emergency Fund
As already mentioned, saving money in an emergency fund can seem like a daunting task. Once you have a goal in mind for the account, you need to have a strategy for achieving it. One of the best ways is to make steady contributions. You can set aside a specific amount each week or month to put into the account.
Even if this amount is small, you will be surprised how quickly the account accumulates money when you are consistent. Check in on the account regularly to make sure you are on track and celebrate the milestones you hit. After all, savings is hard, and it is worthwhile to recognize when you have saved enough.
Automating your savings is the best way to grow the account. You may be able to set up an automatic monthly transfer to the account or choose a certain amount form each paycheck to go to it. However, you should also keep the account in mind whenever you come across a windfall. If you receive a bonus at work or inherit money, this can be a great way to boost the emergency fund.
Once you have achieved your goal, you no longer need to save money in the account regularly, so it pays to use these windfalls to fund the account. Importantly, whenever you dip into the emergency fund, you will need to resume regular payments to bring the account back to its baseline.