An emergency fund is a financial safety net that covers unexpected expenses or financial downturns. The goal of an emergency fund is to have money available to you when something occurs that is expensive and too hard to pay for out of your budget.
Emergency funds should be easily accessible and are usually kept in a savings or money market account. That ensures you can access the money without penalties or delays in emergencies.
Here are the primary components and considerations that go into establishing and maintaining an emergency fund:
- Emergency spending: From time to time, everyone encounters unexpected expenses. You might want to account for potential scenarios like medical emergencies, significant home or car repairs, or expenses related to unexpected life events (e.g., a funeral). Ideally, you will have insurance coverage to pay for most of these expenses. Still, deductibles and out-of-pocket maximums can easily be significant expenses.
- Ongoing living expenses: If you lose your job or see a significant reduction in pay, you'll want to have funds on hand to pay for your daily living expenses. That includes rent or mortgage payments, utilities, groceries, transportation, health insurance, debt payments, and other monthly expenses.
In determining how big your emergency fund needs to be, you'll need to understand your exposure to unexpected expenses and your minimum monthly living expenses.
Financial advisors typically recommend setting aside three to six months of living expenses. The exact amount can vary based on individual circumstances, such as job stability, health, and the number of income earners in the household.
You may not have a lump sum on hand to immediately fund your total emergency fund need, but it is something you can build over time. Building an emergency fund isn't a one-time task. It's essential to contribute consistently, especially after you've withdrawn from it. Regular contributions can help grow and maintain the fund, even if it's a small amount.
The calculator below can help you understand your specific need and what it will take to build the emergency fund to protect you from financial surprises.
It's essential to reassess your emergency fund periodically. As your living expenses or financial situation change (e.g., after buying a house, having children, or getting a new job), the amount you need in your emergency fund might also change.
While it's crucial for peace of mind and financial security, having a large sum of money in a low-interest savings account does come with opportunity costs. It's a balance between ensuring easy access to the funds and potentially earning more through other investments.
While not a direct component of the fund, it's essential to consider the role of insurance. Having adequate health, auto, disability, and home insurance can reduce the amount you might need to pull from your emergency fund in certain situations.
Some people find it beneficial to set milestones when saving for their emergency fund. It can make the process more manageable and motivating.
An emergency fund is a blend of savings, strategy, and foresight to ensure financial stability during unforeseen circumstances.