- Introduction
- Setting up and funding your emergency savings account
- Emergency savings dos and don’ts
- Types of emergency accounts
- The bottom line
Set up your emergency fund: Saving for a rainy day
- Introduction
- Setting up and funding your emergency savings account
- Emergency savings dos and don’ts
- Types of emergency accounts
- The bottom line
Life is full of surprises, and bad luck can hit at the worst times. Maybe your car breaks down, the water heater springs a leak and needs to be replaced, or you lose your job.
An emergency fund, also known as a rainy day fund, is savings set aside specifically for paying unexpected expenses, regardless of what they are or how they come about. Key to an emergency fund is liquidity—the ability to access your savings quickly and easily, whether that’s by writing checks, withdrawing cash from a bank teller or automated teller machine (ATM), or using a debit card.
Savings and checking accounts are often recommended as the best places to store emergency funds, thanks to their relative safety and ease of access. Savings accounts—and some checking accounts—pay interest, but the interest rates are typically lower than, say, a certificate of deposit (CD). But with a CD, you’ll be charged an interest penalty if you withdraw the funds before the maturity date, whereas you can pull money from a checking or savings account whenever you need it.
Consider using a checking account for daily and monthly spending, and keep your emergency fund sequestered in the savings account. That way, you’ll always know how much money is there for emergencies. Plus, even if the interest rate is low, it will still likely be higher than the rate on your checking account.
Key Points
- Identify your essential expenses.
- Set goals and start small.
- Keep your emergency fund safe, stable, and readily available.
Setting up and funding your emergency savings account
An emergency fund can help you better handle the financial burden of unpleasant surprises. How much money you need in an emergency fund depends on your situation, but many financial experts suggest having three, six, or even nine months’ worth of expenses in a savings account that you can tap easily. That may seem like a lot to save, but you can build your emergency fund over time.
Start by opening checking and savings accounts at a bank or credit union, whether online or at a brick-and-mortar institution. Next, set up automatic transfers from the checking account to the emergency savings account to keep things simple and keep the fund increasing consistently. It’s OK if you need to start small; just keep adding to the fund and let the savings grow.
Not sure how to estimate your regular expenses? Take a look back at your spending on essential living costs over the past year. Everyone’s expenses vary, but these items are common:
- Mortgage or rent payments
- Utilities
- Transportation
- Food
- Medical costs
- Other debt payments (such as student loans)
- Childcare
- Education
- Child support and alimony
Although financial pros recommend aiming for three, six, or nine months’ worth of expenses, a lot depends on your personal situation. If you have other assets, such as an investment portfolio or equity in your home, you might opt for an emergency fund with a more modest balance. Also consider the type of job you do and the field you work in. If work is plentiful in your field, then maybe you only need a three-month cash cushion.
Some financial advisors take a more formal approach and calculate an emergency fund ratio, which compares the sum of all of your liquid assets to your mandatory expenses. The emergency fund ratio can help you determine how prepared you are to deal with a financial shock.
Budgeting 101
Need help creating a monthly budget? It’s easy once you break it down. Learn how to set a budget you’ll stick to. And be sure to review it once a year.
Emergency savings dos and don’ts
Fully funding an emerging savings account may seem daunting. Follow these dos and don’ts when creating a fund:
- Do open a separate account and nickname it “emergency savings” or “rainy day account” to keep it separate from other accounts, such as a checking account or other savings.
- Do set a specific savings goal. It’s a good idea to start small. Saving for six months’ worth of expenses is tough, so break it down. Start with a goal of $1,000. Saving $25 a week for a year equals $1,300. Once you achieve that goal, set a bigger one.
- Don’t use your emergency fund to save for other large financial goals, such as a down payment for a house or buying a new car.
- Don’t include money you’re planning to spend on vacations or other discretionary items. An emergency fund is strictly for necessities.
Types of emergency accounts
As boring as it may sound, an emergency fund should sit in a savings account where you can access it instantly. Don’t invest the money in your emergency fund—you don’t want it to be subject to stock market volatility. Plus, if you were to lose your job, it might be more likely to happen during an economic downturn, which is also when stock markets tend to get pounded.
You may not earn much interest on a cash savings account, but emergency money is designed to be tapped whenever you need it. Your emergency savings needs to be both stable and liquid. Money in a liquid account can accessed at any time and used immediately.
Types of bank accounts often used to stash emergency savings include:
- Traditional savings, once known as passbook savings accounts.
- High-yield savings, which usually pay a higher annual percentage yield (APY) than standard savings accounts.
- Money market accounts, which combine the features of savings and checking accounts. They pay interest on the balance and offer the ability to write checks or use a debit card, although the number of withdrawals is limited.
A certificate of deposit is one type of bank account that’s not well suited for emergency savings. Although CDs frequently offer better rates than traditional savings accounts, they require that your money remain untouched for a set period, ranging from a few months to several years. You can still access your funds in a pinch, but if the CD hasn’t matured, you’ll likely forfeit any interest you’ve earned and might even incur penalties that could eat into your initial deposit.
An emergency savings fund can help pay for expensive repairs to your car or home. Without that cash cushion, you might have to use a high-interest credit card, take out a short-term (“predatory”) loan, or juggle bills and risk late payments. Those costs can escalate quickly and negatively affect your credit rating.
The bottom line
Life happens. Don’t feel bad if you have to tap your emergency account before you reach your savings goal. Instead, look at it this way: The emergency fund proved its worth by helping you avoid additional expenses and hassles. Just keep your savings on autopilot so that you quickly replenish that rainy day fund.