The Emergency Fund Rule: To Get One
The world throws a lot of curveballs, and it can make financial stability feel like a moving target. It can also make the feeling of being financially secure seem elusive and unrealistic. According to a survey conducted by LendingClub and PYMNTS, as of early 2023, approximately 60% of Americans were living paycheck to paycheck. As of 2024, a study conducted by Payroll.org found that 78% of Americans are living paycheck to paycheck.
These numbers show an alarming eighteen percent jump from the previous year. The survey conducted in 2023 included individuals across various income brackets, which indicates that living paycheck to paycheck is a widespread issue impacting both low and higher-income earners.
Often known and credited as the foundation of financial wellness, this is where the emergency fund enters the scene. But how do you build one, especially when you are on a tight budget? In this guide, we dive into the emergency fund rule, exploring the definition of an emergency fund, its importance and misconceptions, and recommended practices. We will also break down a simple process of creating an emergency fund into realistic and achievable steps that can work for many, not the lucky few.
What is an Emergency Fund?
Put simply by financial planner Dave Ramsey, “An emergency fund is your safety net”. You could also call an emergency fund a financial buffer, but whatever you want to call it, it is a portion of savings set aside to help cover unexpected expenses that might come your way. Your emergency fund is there to help cushion the blow when life throws you those curveballs.
But still, what exactly makes it so important and worth the trouble of setting one up? Well, an emergency fund prevents unexpected events that happen in life from turning into a crisis. An emergency fund is crucial not only for immediate financial security but also for long-term financial health as well. Studies show that households with emergency savings are less likely to experience financial instability and more likely to recover quickly from economic shocks. As a bonus, having an emergency fund can improve your credit score over time by reducing the need for high-interest loans. This is due to being more prepared to navigate financial surprises without resorting to high-interest debt, such as credit cards, payday loans, or predatory loans.
Now that we have an understanding of what it means and its importance, there are some common misconceptions when it comes to emergency savings. So, before we jump into the emergency savings rule, let’s explore some of them and clear them up:
“I’m on a Tight Budget, I Don’t Earn Enough to Save”
Research suggests that consistent small savings, even as low as $5 a week, can significantly contribute to an emergency fund over time. Even if you are on a low income, saving even a tiny amount can accumulate over time and provide a safety net for unexpected expenses. Because over time, small contributions accumulate into a significant safety net. Moreover, financial institutions often provide tools and incentives for small savers.
“I’ll Use my Credit Card for Emergencies”
Relying on credit cards can lead to or increase debt obligations and also come with high interest rates. An emergency fund provides a safer and debt-free option to handle unexpected expenses.
“I Have Other Savings”
While having other savings accounts is certainly beneficial, it’s important to understand that your emergency fund is different from your other savings, and the purpose it is for, which is to be available for immediate use in an emergency and/or unexpected situation. There are various reasons why touching your other savings accounts is not ideal, but some top factors to take into consideration are you may lose or significantly deplete your nest egg (savings pool for the future, such as retirement). You may also face taxes and penalties, depending on the type of account you are withdrawing from.
These are some common misconceptions when it comes to creating an emergency fund – don’t let it deter you from creating one. Now, let us clarify The Emergency Fund Rule.
The Emergency Fund Rule
The Emergency Fund Rule is to get one. It is highly recommended and crucial. During economic downturns, having even a modest emergency fund can mean the difference between maintaining stability and facing significant financial hardship. Check out this Urban Institute study that provides detailed insights into the importance of having emergency savings to buffer against economic shocks. But if that is not enough to convince you, here are some top reasons you may want to consider setting one up for yourself:
Job Insecurity
A stable job isn’t always a guarantee. Unforeseen circumstances such as layoffs and employment cuts can occur, leaving you without a steady income if this were to happen. An emergency fund can help carry you during these periods, reducing the stress and worry about meeting your immediate bills and necessities.
Health & Medical Emergencies
Ill health or accidents are unpredictable and can quickly lead to high medical costs. In such cases, an emergency fund can be a lifesaver, averting the need for loans or financial aid, and ensuring you receive the care you need without delay or worry. A study published by The American Journal of Public Health found that a significant number of bankruptcies in the U.S. are due to medical expenses.
Maintaining Credit Health
With an emergency fund, you can avoid resorting to high-interest credit cards or predatory loans during urgent situations, this in return helps preserve your credit health. The Consumer Financial Protection Bureau correlates strong financial well-being with having liquid savings available for emergencies.
Unplanned Expenses
Life is full of surprises, isn’t it? They aren’t always pleasant – a damaged car, house repairs, or even a sudden trip. An emergency fund allows you to handle these unexpected costs without disrupting your regular budget or falling into debt. It is estimated that 40 percent of Americans would struggle to come up with $400 for an unexpected expense if something were to happen (Source: U.S. Federal Reserve) and it helps shine a spotlight on why the emergency fund rule is important.
Financial Independence
Last but not least, an emergency fund empowers financial self-reliance. It grants you the leeway to make decisions based on preference rather than immediate need, which can be critical during moments of crisis.
Creating Your Emergency Fund
Now that we are aware of what an emergency fund is, its importance, and its misconceptions, we’ll explore the practical steps we can take to build one:
Understand Your Essential Expenses
Start by listing your essential monthly expenses. Including but not limited to:
- Rent or Mortgage: Your housing costs are not negotiable.
- Utilities: Electricity, water, heating, internet, and phone — these are necessary for everyday living and something to consider.
- Groceries: Food is another essential category.
- Transportation: Whether it’s public transport or gas for your car, transportation may be important to you.
- Insurance: Health, auto, and any other critical insurance should be accounted for.
- Debt Payments: Minimum payments on credit cards, student loans, and other debts.
Set a Realistic Savings Goal
Once you’ve your expenses figured out, it’s time to decide on a savings goal for your emergency fund. The most commonly recommended amount is three to six months’ worth of living expenses tucked aside. But, if you are getting started or facing financial hardships, this doesn’t need to be a large number. The goal should motivate you, not discourage you from achieving your goal. Even $500 can make a significant difference in an emergency. What is important is to aim for what is realistic for you and your unique circumstances, especially if you are just getting started or are facing financial difficulties. Remember, the emergency fund rule is to get one, not to try reaching for an unattainable number.
Budget Smartly
Create a simplified budget and identify areas where you can save, even if only a few dollars. A budget helps track income and expenses, identifying areas where you can cut back and save more. For some, you may consider advanced savings strategies such as the 50/30/20 rule, where 50% of your income goes to necessities, 30% to discretionary spending, and 20% to savings.
Automate Your Savings
Automation encourages and ensures consistency. You can start small and gradually increase the amount as you adjust your budget. Set up automatic transfers from your checking account to your savings account if this is a possibility for you. Even transferring $10 per month can help you slowly build your emergency fund. At a few different points in my life, all I could afford to save was maybe ten dollars a paycheck, but watching it slowly build was highly motivating and felt good.
Remain Flexible and Adjust
Life changes, and so should your savings strategy. Regularly reviewing and adjusting your budget and savings goals is optimal. As you pay off debt or increase your income, you can gradually fund your savings more, little by little. You may also need to save less for one month to remain flexible and adjust. However, continue to save something, even a few dollars. It will help you feel encouraged to keep up the good habits.
Find a Place to Keep Your Emergency Fund
When you start saving, you don’t need fancy accounts. A simple savings account, where you can easily access your money, will do. If you aren’t at the beginning of your savings venture and are considering other avenues, these may be worth exploring:
- High-Yield Savings Account: Provides easy access and better interest rates than traditional savings accounts.
- Money Market Accounts: Offer higher interest rates with limited check-writing abilities.
- Certificates of Deposit (CDs): This is more of a recommended option for longer-term savings. Ensure you have some liquid savings available for immediate needs. Withdrawals on CDs can potentially cost you a penalty.
Key Takeaways
I hope you take away from this article that building an emergency fund does not require a high income. It requires consistency and the willingness to start small. When you follow the emergency fund rule, you can be prepared for uncertainties and navigate financial challenges confidently. Beyond financial security, having an emergency fund provides significant psychological benefits. It reduces anxiety and stress associated with money troubles, allowing you to focus on long-term financial goals. Studies in finance psychology have shown that individuals with emergency savings report higher overall life satisfaction and mental well-being. That is a top-tier reason to get started saving!
You can start by assessing your expenses, setting a savings goal, and automating your contributions if possible. Your future self will thank you! You’ll safeguard your present and future and alleviate so much stress off your back.
Ready to take control of your finances? Explore our Fundamentals 101 and Budgeting Blueprint for more tips and strategies on financial wellness. And remember, financial literacy is the key to unlocking a world of opportunities. Join my mailing list so you are the first to know when new blog posts are published. Happy learning!
How has an emergency fund helped you? Share with me at [email protected].
Footnotes
- LendingClub – Paycheck to Paycheck Report. Accessed May 29, 2024. LendingClub
- Forbes – Living Paycheck to Paycheck Statistics 2024. Accessed May 29, 2024. Forbes
- The American Journal of Public Health. “Medical Bankruptcy in the United States.” Accessed May 29, 2024. AJPH
- Consumer Financial Protection Bureau. “Financial Well-Being in America.” Accessed May 29, 2024. CFPB
- U.S. Federal Reserve. “Report on the Economic Well-Being of U.S. Households.” Accessed May 29, 2024. Federal Reserve
