Saving is a part of life. You need it to support you through difficult times and give you peace of mind to take risks. A common form of saving is called an emergency fund.
Click to jump to a section:
- What is an Emergency Fund?
- Why an Emergency Fund is Important
- What NOT to Use an Emergency Fund For
- Why the Structure is Important
- How to Best Structure an Emergency Fund
What is an Emergency Fund?
An emergency fund is savings that should only be tapped into for unexpected expenses. This can include:
- Surprise medical bills
- Holding you over between jobs
- Sudden home maintenance
Any other event in your life that causes you to need a significant sum of money to survive suddenly is use for an emergency fund.
An emergency fund will usually be in the form of a bank account or even cash holdings. It will not usually be held in a risky asset. If the funds fluctuate due to volatility, it defeats the purpose of having it to cover you in emergencies.
Emergency funds will often be held separately from other savings. Any savings intended for a large future purchase, such as a house or car, are separate from an emergency fund.
Why an Emergency Fund is Important
An emergency fund is your plan B. Regardless of what happens in your life, an emergency fund should be there to back you up.
This not only protects you if something happens but gives you comfort knowing you have a backup plan.
Too many people go through the world without a plan B, one emergency away from debt. An emergency fund can be that barrier for you.
What NOT to Use an Emergency Fund For
Even though an emergency fund is held in a bank account like the rest of your money, you should treat it differently. These funds should be treated as separate from your “spending money.”
Money from an emergency fund should NOT be used on:
- Recurring expenses
- Food
- Clothes
- Large purchases (car, house, etc.)
- Trips
Using your emergency fund towards these expenses leaves you vulnerable to an emergency.
Let’s say you withdraw $5,000 from your $7,000 emergency fund to help with a down payment on a car. You now only have $2,000 left in case of an emergency. This may not be enough for medical bills if something horrible happens.
This isn’t meant to scare you. Instead, it is intended to help communicate the importance of leaving your emergency fund for actual emergencies.
Debt is one of the most challenging things to get out of and can have lasting effects on your financial well-being. Not being able to invest while in debt and straining your credit score are obstacles you don’t want to run into. If you leave yourself with too small of an emergency fund, you could end up in debt, covering a sudden expense.
Why the Structure is Important
Having a bunch of money tucked away for emergencies is a great place to start. However, we can optimize it further.
Setting up the best structure for your emergency fund can give you more savings, peace of mind, more “spending money,” and more opportunities.
It may sound silly to structure money that will sit there, hopefully untouched. But treat these funds as just as important as the rest of your money.
We all want to grow wealth and achieve a more comfortable life financially. Well, if one part of your wealth grows (i.e., your emergency fund), so does the rest. Knowing your emergency fund is well-structured, you can focus more on other aspects of your wealth.
If you stuff $1 bills into a mattress as an emergency fund, first off, save space by getting $10 bills. Second, you are missing out on the security and returns of other methods.
How to Best Structure an Emergency Fund
Let’s cover how to structure your emergency fund to optimize it.
Increase the Friction of Spending It
The biggest obstacle keeping people from saving money is spending it. If you see your savings as available anytime, like cash or a checking account, you are far more likely to spend it.
Your friend pitches a vacation, or you want an expensive outfit but don’t have the money to buy it comfortably. You want it to be difficult to decide to use your emergency fund to buy it. If you keep it in cash or behind a debit card, there is very little friction in deciding to use it.
Instead, you want your emergency fund to be a step or two away from liquid. This increases the friction between wanting to use it and spending it.
This friction can come from needing to transfer funds from your emergency fund to a liquid form. If your emergency fund is held in an asset such as a stock, you have to sell that asset and transfer it. If your emergency fund is in a savings account, you must go through the transfer process.
Either of these setups has enough friction to make you think twice about spending your emergency fund.
The less you spend your emergency fund on things you shouldn’t, the more you will have available for true emergencies.
How Much to Keep in an Emergency Fund
It is great to have your emergency fund set up correctly. But an excellent account is useless if it’s empty. The other half of the equation is how much you should keep in an emergency fund.
There is no exact number of how much to keep in an emergency fund. This figure will vary by person and situation. However, we can set up ground rules to follow.
A traditional rule of thumb is to have 3-6 months’ expenses in an emergency fund. This amount should be enough to cover substantial medical bills or a temporary lapse in employment. However, this should be treated as a minimum.
Prioritize getting to at least 6 months’ expenses as quickly as possible. Speed up the process by prioritizing your emergency fund over other investments and saving. Covering yourself in an emergency is more important than just about anything.
Once you have 6 months’ worth, you can slow down a bit and focus on other savings and investing. However, your long-term goal should be 12 months’ worth of expenses.
This will be enough to cover multiple emergencies or one large one. This should cover even high medical bills and a long lapse in employment. If you decide to quit your job and pursue a passion for income, this cushion will be necessary to survive.
Regardless of how much is in your emergency fund, refilling it should be a priority. If you ever need to spend any of your emergency fund, ramp up your saving to get to where you were before.
Failing to refill your emergency fund quickly defeats the purpose of having one in the first place.
Keep it Separate
You may think, “I already have a savings account, so I’ll keep my emergency fund there.” The problem with this plan is that any time you tap into your savings, you can easily tap into your emergency fund.
It is okay to have traditional savings towards future large purchases. That is a financially sensible way to plan for the future. However, that is no place for an emergency fund.
Say you have $5,000 saved towards a car and $5,000 in an emergency fund. When you buy that car, you may be tempted to put more down or even get a fancier car because you see $10,000 as available.
We all think we have incredible self-control and would never make this mistake, but it isn’t true. We are all human and fall into traps of short-term decisions like spending more than we want.
We’ve all gone to the grocery store and walked out with way more than we planned to buy. Don’t fall into the same trap with larger purchases.
Whether your emergency fund is in a separate savings account with the same bank or an entirely different account, keep it separate.
An emergency fund needs to be reliable to be effective. Keeping it separate lets you rely on it, knowing it is untouched.
High-Yield Emergency Fund
Shift your mindset from thinking of an emergency fund as a sum of money that has to sit there gathering dust. You can set up your emergency fund to build your wealth while it sits there unused.
This can be done by keeping your emergency fund in a high-yield savings account.
Think of a high-yield savings account as a traditional one, except it actually earns solid returns. Most savings accounts earn around 0.01% annually, or basically zero. On the other hand, a high-yield savings account earns about 3-4%, depending on the account you go with.
This is 300 to 400x the returns of a traditional savings account. Plus, you sacrifice nothing. Your funds are still FDIC-insured, and you can transfer them out of the account to spend them when necessary.
Think of these returns as passive income on your savings. Those returns are guaranteed and require no more input than setting up the account.
Keeping your emergency fund in a high-yield savings account is like having a high-yield emergency fund. Your emergency fund now grows your wealth while it sits there.
This 3-4% annual return will compound over time, just like stock market returns. On a $10,000 emergency fund, that is $300-$400 per year, with no extra work. All you have to do is keep your money in a different account.
Saving in a high-yield savings account also helps keep your emergency fund separate from other savings. If you decide to move your additional savings to a high-yield savings account, just make sure to keep it separate.
If you want to keep your emergency fund in a high-yield savings account, read this post covering the 5 best high-yield savings accounts.
Automate Saving
Many people fall into the trap of manually saving and filling their emergency fund. Eventually, these people will forget or prioritize other expenses “just this month”. Then “just this month” turns into a year.
We can avoid this by automating the process of saving. I am a huge fan of automating most financial transactions, such as investing, paying yourself, and saving. This applies to an emergency fund.
To automate your emergency fund, set up automatic transfers. This can be done one of two ways: have your emergency fund automatically pulled from your checking account or direct deposit funds from your paycheck into your emergency fund.
I recommend the second option here. Direct depositing from your paycheck means you never even see the money as available. If you first receive income in your checking account and then transfer it, you tempt yourself to spend while it is available.
Most platforms like SoFi allow for easy setting up direct deposits into your account. This is the definition of setting it and forgetting it.
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