As we all know, unexpected twists can occur in life. Whether it's something big, such as losing your job, or something smaller but still costly, such as a car repair or property damage, it pays to be prepared for whatever life throws at you.
One way to prepare is by building an emergency fund. A key element of wealth planning at every income level, an emergency fund can help you avoid the need to run up a credit card balance or sell assets at an inopportune time, while still covering your essential living expenses.
How much should be in an emergency fund?
Generally, financial experts advise that an emergency fund should have enough funds in cash or liquid assets to pay expenses for three to six months, but how much you keep in your fund will depend on your personal situation.
- Do you share expenses with a partner? If so, you may be comfortable having enough to only cover three months' worth of expenses, since at least one of you is likely to continue generating income even if the other is unable to work for a brief period of time. On the other hand, if you both work in the same business, it might be safer to have a larger emergency fund at the ready in case of a downturn. Households that rely on one income will likely want a larger emergency fund—one that can pay at least six months of expenses.
- Do you plan to leave your job or switch to a new job in the near future? In that case, you may want to increase your emergency fund temporarily, to make sure you can cover expenses in between jobs.
- Do you have a financial safety net, such as support from your family that would be able to help in a financial emergency? You might not need as much in your emergency fund if you know you can rely on them to help out.
- Do you own a home and have a home equity line of credit? That can function as another source of emergency funds, if necessary, in which case you can keep a little less cash on hand and invest the rest.
Beware of keeping too much money in your emergency fund, however, as your cash loses value during a period of high inflation. A large emergency fund can give you a sense of security, but you could miss out on potential growth opportunities if you're not investing excess cash. That's particularly true of millennials who have a long time horizon for building wealth.
Where to keep your emergency fund
The goal for your emergency fund is to have immediate access to the cash when you need it. That doesn't mean you have to keep it in a zero-interest checking account, though. A savings account or a bank money market account that pays interest is best for at least three months of expenses.
Saving for emergencies
The simplest way to build an emergency fund is to set aside an amount that is automatically deposited from each paycheck into your designated account. You should create a budget to understand your expenses, and, if possible, include an allocation for retirement savings, especially if you have an employer match.
After setting up and putting sufficient cash into your emergency fund, you can then tackle other priorities, such as paying off student loan or credit card debt, saving for a down payment on a home, and saving for retirement. Focusing on an emergency fund first can give you a solid starting point to work on your other goals, as well as a peace of mind that you're prepared no matter what happens.