Benefits of an Emergency Fund & How to Build One

Benefits of an Emergency Fund & How to Build One
GUIDE
John Ulzheimer
By: John Ulzheimer
Posted: June 3, 2019
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Dealing with unexpected expenses, like car repairs or medical emergencies, is never fun. For at least 40% of Americans, unplanned expenses have the potential to quickly turn into a stressful financial disaster. The Federal Reserve reports that 4 in 10 adults in the U.S. cannot afford to pay for an unexpected expense of $400, at least not without selling something or borrowing the money.

Think about that for a moment, and ask yourself: what you would do if your HVAC unit died, your dryer stopped working, or your transmission locked up?

Emergencies that require large investments, unfortunately, are an inescapable fact of life. As is true for most people, you’ll likely face unexpected expenses from time to time. The only question is when they’ll happen and whether you’ll be prepared to afford those expenses when they do come up.

Why You Need an Emergency Fund

An emergency fund is a bank account you use to stash away money to cover unforeseen financial surprises. Many financial experts recommend saving at least three to six months of your household expenses to cover situations such as:

  • Illness or Injury
  • Job Loss or Reduction in Income
  • Home or Auto Repairs
  • Unplanned Travel Expenses (Not Vacations)

In addition to helping you prepare financially for the unexpected, a properly funded emergency fund can benefit you in a number of other ways.

1. An emergency fund can protect your credit reports and credit scores.

Financial surprises and the health of your credit often don’t mix well together. It’s not hard to imagine a scenario where you’re sick or out of work and the bills don’t get paid, especially if you don’t have any financial cushion upon which to rely.

When you fall behind on your credit obligations, it can have a serious negative impact on your credit scores. Unfortunately, if you can’t pay your bills during an emergency, any credit score damage you experience will likely haunt you for years to come. In fact, late payments can remain on your credit reports for up to seven years.

Chart Showing Time Items Take to Age Off a Credit Report

Even relying on credit cards to help you make it through an emergency situation could hurt you in the credit score department. When your credit reports show that you are using a larger percentage of your credit card limits, your revolving utilization ratio increases.

Revolving utilization has a profound impact on your credit scores. The lower your utilization ratio, the better. An emergency fund can help you avoid running up a higher credit card balance and thus prevent that issue.

2. An emergency fund can help you avoid unusually expensive debt.

When you don’t have an emergency fund to tap, you may be forced to find other ways to finance unexpected expenses. This may include using a credit card, taking out a loan with your bank or, for some people, turning to a payday lender as the lender of last resort.

While most extensions of credit carry some sort of interest rate fee, not much compares to the punitive interest rates and finance charges associated with payday loans. In fact, they may very well be the most expensive debt you’ll ever service.

According to the Consumer Financial Protection Bureau, the average payday loan features an APR of nearly 400%. When you consider this extraordinarily high cost to borrow money, those unanticipated expenses can cost you far more in the long run than they would had you been able to cover them with money you had set aside in advance in your emergency fund.

How to Build an Emergency Fund

Now that we’ve laid out the reasons why you should have an emergency fund, it’s time to explore ways to actually build one. While the specific methods you use will depend on your personal situation — including your current income, debts, and other financial responsibilities — here are some general tips to building a solid emergency fund.

1. Start Small

Although your eventual goal may be to stash away the cash equivalent of three to six months of expenses in your emergency fund, it’s important to start out with a realistic goal. Take a look at your budget and figure out how much you can afford to save each pay cycle.

Pro Tip: I recognize and respect that many financial planners suggest keeping three to six months’ worth of expenses in reserve. Given how expensive some emergencies can be, I actually prefer to recommend six to 12 months instead.

2. Automate Your Savings

Once you’ve determined how much money you can afford to funnel into your emergency fund each month, it’s a good idea to consider automating your savings. For example, you could set up an automatic savings plan to transfer $50 per week — or any amount that works for your budget — into your emergency fund.

Your bank or credit union may already have this feature available. It can also be wise to consider setting up a new savings account that’s separate from the account you use to pay your bills — out of sight, out of mind. Online-only banks can be a good choice for this, as they tend to offer lower fees and higher savings account interest rates than brick-and-mortar banks.

Traditional Banks vs Online-Only Banks

By keeping your emergency fund in a separate bank account, you may be less tempted to spend the money on something else. Money tends to burn holes in some people’s pockets so out of sight can mean out of mind.

3. Supercharge Your Savings

If you want to fund your emergency account faster, you may be able to supercharge your savings by cutting your expenses. Many people can reduce their monthly spending simply by lowering their grocery bills and eating out less.

Other tips for saving money include shopping around for lower insurance rates and asking certain service providers if they can give you a better deal.

Another way to find more money to grow your emergency fund faster is by earning extra money on the side. Selling unwanted items or picking up a side gig, even temporarily, can be great ways to help you reach your financial goals sooner.

4. Track Your Progress and Celebrate Milestones

Remember, it will take time to build your emergency fund to a respectable amount. But that doesn’t mean you shouldn’t celebrate your small successes along the way.

For example, if you’re giving up eating out to help fund your savings account, you may plan to treat yourself to a meal out each time you have saved a full month worth of expenses. Remember, you don’t have to give up everything you enjoy to make a savings plan work. Many people simply need to be more thoughtful about their spending habits.