Facundo Abraham, Analyst
In the past few months, we’ve seen runs in the banking sector, significant layoffs in the tech industry and extreme weather events. If anything, these events have shown us the importance of being prepared for the unexpected — and having an emergency fund.
But, even after all that has happened, it’s not uncommon for individuals to neglect their emergency savings. A recent Edward Jones survey found only 40% of Americans consider their emergency funds fully funded, with about one-third of respondents having less than $500.
So, how can you strengthen your emergency fund and create more financial stability? Below, we answer key questions to help you build and more effectively use your emergency fund.
How much should you save?
For most people, maintaining three to six months of total expenses in emergency savings is appropriate. Having three months can generally help you cover a few medium, or one to two large, unexpected expenses. If you work, three months is also the median duration of unemployment as well as the typical waiting period in disability insurance policies.1
Using three months as a starting point, you should increase your target amount if:
- You have a relatively higher risk of unexpected expenses. Think, for example, if you have poor health, live in an area prone to natural disasters or have an older house or car that is likely to need repairs.
- You have a relatively higher risk of losing your job or experiencing a temporary decline in income. For instance, consider if you’re part of a single-income household, work in an industry with high turnover or a high share of your income is variable.
- You value the comfort of being able to weather emergencies.
You may wonder if you should save more than six months of total expenses. If your risks are too high or your comfort with risk too low, that could make sense. That said, while going above six months can increase your ability to weather emergencies, it may put you at risk of not achieving your other financial goals, particularly if you have limited savings and are juggling multiple goals. A financial advisor can help you assess your specific situation to help determine where within the range, or even above it, you should be.
How can you build your savings?
If you’re wondering how to start an emergency fund or save more money in the one you have, you can use a few of these tips and tricks. For example, you can start saving a portion (or all) of any extra income, such as bonuses and tax refunds, or expenses you budgeted for but ended up not spending. You can also find ways to save in your budget. For instance, cancel subscriptions you don’t use regularly or take advantage of sales for large, planned purchases.
While building your emergency fund is important, it’s also important that you don’t neglect your other goals. For instance, while you want to make progress on your emergency savings, you don’t need to fund them fully before paying down high-interest debt or saving enough to get an employer match for retirement.
Where should you hold your emergency fund?
Keep your emergency savings in a separate account. That way, you can easily know how much you have saved while reducing the temptation to use these funds for everyday spending or to fund other goals.
As far as the type of account, we recommend holding your emergency fund in cash and cash equivalents that have low risk and are easy to access. While you shouldn’t put your emergency fund in investments like stocks and bonds, favor accounts that earn interest. Earning interest can help partially offset the trade-off of not being able to invest your emergency fund.
When should you use your emergency fund?
It’s important to understand when it’s appropriate to use your emergency fund. Using your savings for non-emergencies or, in turn, not using them when they are actually needed can have the same negative effect: You might end up using high-interest debt, tapping into retirement funds or other investments, or getting behind in your payments, all of which can disrupt your goals.
You should use your emergency fund in these two circumstances:
- Pay for one-time, necessary expenses that are unexpected. After using any excess cash, expenses like a broken-down car, malfunctioning heating/cooling system or medical expense should be covered with your emergency funds. Essentially, these are any expenses that, if not addressed, would substantially disrupt your daily life.
- Pay for regular, necessary expenses after a temporary loss of income. If you lose your job or your income is temporarily reduced, you should use your emergency funds to cover the gap between your income and your necessary expenses.
An emergency fund is not only for when “bad” things happen. When you have the confidence that you can cover your expenses, you can feel empowered to follow your dreams and pursue what’s best for you (such as leaving an undesirable job or relationship, taking more time off after the birth of a child or going back to school). You can use your emergency savings to cover any temporary loss of income during these times.
An emergency fund can help you cope with unexpected events without derailing or delaying your goals and give you more freedom to live life the way you want. A financial advisor can help you start building an emergency fund or, if you already have one, make sure it’s appropriate for your needs.
1. Median duration of unemployment during 2000–21 from the Bureau of Labor Statistics (BLS).