What is an emergency fund? Here’s what you need to know

Ever found yourself sick and unable to work? The victim of unexpected corporate layoffs? Stranded with a car that just won’t start?

Though the idea is not so easy to swallow, unexpected events like these can happen at any time.

Whatever the reason, when costly emergencies arise or life takes an unexpected turn, you’ll likely need a financial cushion to fall back on.

The solution? Emergency savings.

What is an emergency fund?

An emergency fund (AKA a rainy day fund) is cash that’s set aside to cover the cost of unexpected, and often expensive, events. An emergency fund is not a personal slush fund for when your skis break or for when you’re eyeing a new dress for your best friend’s wedding. Instead, emergency savings are meant to be used for real, urgent needs—like paying rent when your income dries up or footing a medical bill without having to rack up a balance on your credit card, take out a loan or tap into your home’s equity.

In other words, it’s a good idea for everyone to have an emergency savings account—regardless of your income or wealth—because unexpected expenses and situations can happen to anyone.

How much do you need in emergency savings?

One of the biggest financial shocks is the loss of a job. According to the U.S. Bureau of Labor Statistics, the average length of unemployment is about 27 weeks. Most experts recommend that you build up your emergency savings so they could cover a setback at least that long. If you don’t have this kind of cash lying around, don’t sweat it. You can start small and work your way up. One month’s worth of take-home pay is a good start. Three months is even better. And six months is a solid long-term goal.

“When building an emergency fund, it’s okay to start with a small number as your goal: $500 or $1,000 is a great place to start,” says Philip Taylor, founder of a personal finance blog. “You won’t be so intimidated, you’ll meet your goal quicker and you’ll be able to use the momentum of hitting this goal to push you toward a bigger cushion, like six months’ worth of expenses.”

Where should you keep your emergency fund?

Before you can actually start building your emergency savings, you need to decide where you are going to keep the money. Because your emergency fund is meant for sudden events, you’ll want to make sure you can access your savings easily. However, it may be best to separate this money from your other accounts to reduce the temptation to dig into it for treat-yourself spending. Plus, keeping your emergency savings in an account protected by FDIC insurance, as opposed to stocks or other investments, means your account will be insured up to the maximum allowed by law.

Although some consumers worry that money sitting in a traditional savings account accruing little annual interest is, essentially, wasted money, there is a premium to having funds that are accessible. In a true emergency, you may need to access your funds right away and may not have the luxury of waiting days, or even weeks, for them to transfer from other types of accounts. You can also shop around for a high-yield online savings account so your emergency savings account is earning interest while it’s parked for future use.

While you may want to consider using an online savings account for the first couple months’ worth of expenses, think about putting the rest of your emergency savings in a money market account or a certificate of deposit (CD) to earn additional interest.

How should you save for your emergency fund?

To help keep your savings goals on track, make your emergency fund contributions part of your monthly budget. Bonus: You can automate your savings to remove any chance that money you planned to save for emergencies will be used for something else.

Making automatic deposits each month is easy. Just choose the amount you want to contribute to your emergency savings account, and then set up a direct deposit to take the money out of each paycheck. You can also set up an automatic transfer each month to move money from your checking account to your emergency fund.

“It’s out of sight, out of mind,” says Kerri Moriarity, head of company development for a Boston-based startup building financial software. “Since the transfers happen automatically, it eliminates the ‘pain’ of choosing to transfer money out of your checking account to set aside for an emergency.”

Should an emergency fund come before paying down debt?

Experts have different opinions on whether or not you should save for an emergency when you have credit card debt to pay off. While many decide to postpone saving when they have credit card debt, Marc Roche, co-founder of a blog about investment strategies, offers another recommendation.

“While there is financial truth that it will cost you more to pay double-digit interest on a debt balance when you’re lucky to make 1 percent interest on your savings, there is a cost to the risk of not having savings,” he says. “If you had a financial emergency and no cash, you’d have no choice but to turn to high interest credit cards and loans, or worse, foreclosing on your home and even bankruptcy,” Roche adds.

But what if you are paying 15 or even 20 percent in interest on your credit card debt? There may be a point when it makes sense to divert extra funds to paying down this debt before going into savings mode for your emergency savings account. The key is to find a sweet spot where you can pay down your debt and still contribute to emergency savings each month.

Building your emergency fund—and beyond

You should now be able to answer the question “what is an emergency fund?” and see that an emergency savings account will provide you with a safety net and peace of mind if you come face-to-face with an emergency. However, it’s important to remember that you can’t just set up the account and forget about it. If you find yourself in a position where you need to dip into your emergency savings, be proactive about replenishing your account so it’s ready to go for next time.

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