Any good budget has an emergency fund. You might have heard people talking (or even screaming) that cash is trash over the last two years with inflation running rampant in 2021 and 2022. While it is true that inflation has a negative impact on cash, having an emergency fund that is liquid and somewhat easy to get to is equivalent to car insurance. Yes, you may never need to issue a claim, but if an accident occurs, you will be thankful that you paid for the good insurance.
What Is An Emergency Fund?
An emergency fund is money you have set aside to handle unexpected life events (such as an unplanned big expense or losing a job). Typical emergency funds contain 3 to 6 months worth of expenses in them. Additionally, emergency funds are generally held in accounts that require an extra step to access. Here are the three steps I took when creating our emergency fund:
Step one: Determine how much money needs to be in your emergency fund.
There are multiple things to consider when figuring out how much money you need to keep in your emergency fund. First, you must know your bare bone monthly expenses. If you do not know how much you spend a month, feel free to check out my post on budgeting.
When I say bare bone monthly expenses, I mean just the essentials. To the right is a list of what I include as part of our essential monthly expenses. As you can see, I do not contain any area for frivolous spending in our emergency fund. If an emergency occurs, such as a big expense comes up or we get fired from our jobs, we will not be living lavishly. But, we will have enough saved to get by until we overcome the situation.
The second thing you must consider when determining how much money to have in your emergency fund is your income source. If you own your own business or work in a position where sales commission makes up a large part of your paycheck, leaning towards the 6 months worth of monthly expenses in your emergency fund would make sense.
However, if you have had a stable source of income for many years that does not change from month to month, you may be safe keeping 3 months of monthly expenses in your emergency fund.
Another thing to consider is who else relies on your income. If you are a family of four with one income source, a 6 month emergency fund would be necessary. But, if you live alone and have no one else relying on your income, having 3 months of expenses might be okay.
Once you have determined a number that you are comfortable with, move on to step two.
Step two: Save money monthly to put towards your emergency fund until fully funded.
This steps seems obvious, but it is very easy to put off saving money you may never need. This is why you must make saving for your emergency fund automatic. Every paycheck, set aside a certain percentage to go directly towards your emergency fund. In general, I like saving 25% of our gross income. Therefore, I would put 25% of our gross income into our emergency fund per paycheck until it was fully funded. If you would like some tips on how to save money, feel free to read how we use a categorical approach to savings.
Step three: Make your emergency fund hard to touch.
I like putting an emergency fund into an online high yield savings account (or "HYSA") that is FDIC insured. We personally use Marcus by Goldman Sachs (current interest rate of 3.3%) and do not currently have any complaints. Most HYSAs also allow you to set up automatic monthly transfers, which will help you complete step two above.
Using a HYSA to store an emergency fund accomplishes two things for me. One, it creates a barrier between me and the money. With a HYSA, I must do a bank transfer that can take 24 hours before having access to the funds. This helps keep me from using a HYSA for daily non-emergency purchases.
The second thing it does is keeps the money liquid. Having an emergency fund in a savings account instead of something like a treasury bond allows you to have relatively quick access to the money. If it is too difficult to access an emergency fund, it may defeat the purpose of having one in general.
Summary
Here is a breakdown of the steps I used to create our emergency fund:
Determine how much money needs to be in your emergency fund.
First, figure out your bare bone monthly expenses.
Second, figure out how stable is your income source.
Third, take note of who else relies on your income.
Save money monthly to put towards your emergency fund until fully funded.
Make this step automatic if possible.
Make your emergency fund hard to touch.
I like using an online high yield savings account (or "HYSA") that is FDIC insured.
At the end of the day, hopefully you will never have to use an emergency fund. Unfortunately, you must plan for life throwing unexpected curveballs your way.
If an emergency happens, the last thing you want to do is pull money from your retirement investment accounts or take on debt. Thus, having an emergency fund is the perfect way to avoid having a terrible event derail your family's financial health.
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