Building a strong foundation is one of the most important steps along the road to financial security. One of the pillars for financial independence is an emergency fund.
An emergency fund can help get through some of life’s financial hardships. It is exactly what is sounds like: money set aside for unexpected expenses such as a busted water line or a medical mishap.
“An emergency fund is cash you can get to quickly without having to liquidate stocks or investments,” said Joy Garland, a Certified Fund and Income Specialist and Managing Partner for Roan Capital Partners. “It’s money you keep in a bank in a separate checking account or savings account.”
The money set aside in an emergency fund should not be used for expected expenses such as utilities or Christmas gifts. It also should not be used to cover shortfalls on those expenses. It should not be used for a vacation or a shopping spree.
Now that we’ve covered what an emergency fund is and what it should cover, how do you build one?
Pre-planning to build an emergency fund is key. Not everyone is creating a cushion to soften the blows of an emergency. According to Investopedia, it is estimated 28 percent of Americans have no emergency savings at all.
The first thing to do is to figure out what amount would provide peace of mind. For some, that is being able to cover three to six months of expenses while for others, it could be an entire year of expenses. It all depends on the individual.
“You always hear six months or 12 months, but I think in real terms during a person’s early career, that’s not realistic,” said James Ferguson, a Certified Financial Planner and Managing Partner for Roan Capital Partners. “It may not be realistic in mid-career, especially if you have a family. When you’re working, I would say ideally you would have enough to cover two mortgage payments, at a minimum.”
To get to a realistic number of what a person would need to save, they need to calculate bare bones expenses like rent, utilities, car payments, etc. According to Listen Money Matters, the emergency fund should not include items like dining out, entertainment, or clothing expenses.
But even the bare bones expenses could add up to thousands of dollars. It can be overwhelming to think about saving that much money. Just remember, it does not all have to be saved at one time and should be built up over a period of time.
“Usually what you do is start on the small end and say this is my safety net if I get into trouble,” Ferguson said. “You try to build it up. One of the things I’ve seen people do is take a tax refund and start that way. If you get $1,000 back, go ahead and start an emergency fund with that. I’ve seen that work for some people.”
Another way to establish an emergency fund is by putting a small amount, like $50 a paycheck, into a separate bank account. When it goes in, do not touch the money and try not to think about it. Sometimes using a completely different bank or credit union can be helpful to avoid using the money.
Once the goal of three months expenses has been reached, what then?
Ferguson recommends to keep saving but possibly look at placing money in different avenues for more long-term gain. Placing money in a CD or a Roth IRA could help grow the investment over time. It would be less accessible but could provide a greater return.
Roan Capital would not recommend anyone saving more than 12 months expenses in an emergency fund.
“Anything beyond that, you should start investing,” Garland said. “It all depends on the person. If they are very security-minded, they may need three years’ worth of income saved up. It’s above and beyond but that’s what helps them to sleep at night because they know they have it. Starting the fund is the important part.”