Emergency Funds

An emergency fund is money that is set aside to cover basic living expenses or unexpected expenditures in the event that a person experiences a loss of income or an incident involving unplanned expenses. Examples of emergencies are job loss or decreased wages, medical and dental expenses, major home and car repairs, and unexpected travel. This money is also often saved in anticipation of expenses related to accidents; situations when an individual or family member has a health or legal issue; and disasters, such as fires, floods, and hurricanes.

The purpose of an emergency fund is to prevent a financial crisis and to allow individuals to meet their financial obligations without incurring unnecessary expenses or going into debt. Having emergency savings provides not just financial security but also peace of mind. The existence of these funds allows individuals to make considered decisions, rather than being forced to make decisions based on a lack of funds.

An emergency fund provides a safety net so that individuals or households can continue to pay for basic necessities despite disruptions in their customary financial situation. An emergency fund, however, is not a savings account for special items such as a car, house, or vacation; retirement savings; or a backup for times when an individual’s paycheck fails to meet the household’s expenses. This money is designated specifically for one purpose and should be considered personal insurance against unforeseen events and circumstances.

Background

A 2015 survey conducted by financial services company Bankrate found that 29 percent of Americans had no emergency savings. About 21 percent had some emergency savings, but only enough to pay necessary expenses for three months or less. In Bankrate's 2024 survey, 62 percent of those surveyed felt behind on their emergency fund savings, and four out of five individuals reported they had less savings at the end of 2024 than they did at the start of the year.

Experts disagree on how much money is needed for an emergency fund. Some recommend setting aside enough money to cover expenses for three months. Others use three to six months as a rule of thumb. Still others suggest enough money to cover necessary expenses for one year.

One point that experts do agree on is that an emergency fund should cover only necessary expenses, not all of an individual’s or household’s expenses. Necessary expenses are essential costs, such as a mortgage or rent, car payments, health insurance, utilities, transportation, gas, childcare, and food. Nonessential expenses are those based on wants, not needs, such as entertainment, dining out, and vacations.

How much one needs to set aside for an emergency fund depends on an individual’s personal situation and traits. If the 21 percent of Americans with emergency funds covering less than three months of expenses have stable jobs, live in dual-income households, or have skills that are in high demand, three months of emergency savings may be adequate. Individuals with highly marketable skills are the least likely to be unemployed for prolonged periods in the event of a job loss. In dual-income households, individuals still have some source of income, so they may be able to accommodate the loss of one income by reducing some unnecessary expenses, such as subscribing to cable television and eating out, and properly budgeting. Those with stable jobs may have little need to be concerned about the possibility of a job loss.

In contrast, people who are self-employed, freelancing, retired, or working in occupations that are highly specialized or in little demand may need more than three months of emergency savings. For example, it will likely take longer for a person with highly specialized skills to find a new job than it will for a person with a marketable skill in an industry with many job openings. People with irregular or limited income, such as the self-employed or retired, may need a larger emergency fund as a buffer due to the instability or narrowness of their income stream.

Other variables that affect how much money needs to be set aside in an emergency fund include the value of one’s home and automobile. In general, it will cost more to make repairs and replace items, such as a roof, in a large, luxury home than in a small bungalow. The same applies for unexpected car repairs. A broken transmission on a luxury automobile will cost more than one for an economy compact.

Individuals with known risks, such as a house in poor condition or an aging parent or family member with a health concern, also need to set aside more money for emergency savings. In the case of a house in poor condition, the potential for needing repairs is high. Ideally, a person should have a separate savings account for house maintenance and repairs, but having an emergency fund can prove providential for sudden, emergency repairs. Similarly, when an individual or family member has a health concern, the potential for medical or medical-related expenses increases. Even if health insurance covers all medical expenses after the deductible and out-of-pocket costs have been reached, a serious medical condition can require unpaid medical leaves, travel expenses, additional childcare expenses, and food expenses.

To determine how much to set aside in an emergency fund, individuals should create or review their monthly budgets to establish the amount of money needed for essential expenses. Then, they must examine their individual situations and traits to assess how likely they are to experience a job loss, change in income, or unexpected expenses. Next, they need to determine the potential duration of a period with income loss or additional expenses. Multiplying the number of months by the amount of monthly necessary expenses determines the total amount needed for emergency savings.

Overview

Even though many people find setting aside money difficult—especially during times when the cost of living is continuously increasing—experts urge everyone to reserve some money every month for an emergency fund. Even if the deposit is small, such as fifteen dollars per month, this amount will progressively accumulate and help to alleviate financial difficulties if an emergency arises. In addition, one must be sure to monitor and replenish the fund after the money has been withdrawn for an emergency to bring the balance back up to the desired amount.

Setting aside money for an emergency that may never happen may seem unrealistic to individuals who do not normally have disposable income and are struggling to pay their basic household expenses. However, when faced with an emergency, an individual with no financial reserves must often turn to options that are costly or risky. A common choice is charging unexpected expenses on a high-interest credit card. If the individual is unable to pay the balance in full, the interest adds up, making the initial expense even more costly. If a person cannot meet even this financial obligation, late fees and other penalties also accrue.

Another common choice when dealing with unexpected expenses, especially large ones, is to take out a high-interest loan or an additional mortgage. Like credit cards, both have significant costs. Some people dip into other savings, such as college savings. While this act may not cost an individual any extra expense, it sets back that other goal. Withdrawing money from an individual retirement account (IRA) or a 401(k) will cost money in fees and tax penalties.

Deciding not to pay bills also has huge consequences. Unpaid bills negatively affect a person’s credit score, which results in higher interest rates for credit cards and future loans, such as car and home purchases. Unpaid bills can further lead to bankruptcies and house foreclosures, financial disasters with significant long-term effects.

Experts also advise people to be creative and find ways to generate supplemental income to fund an emergency savings account. Options include taking a temporary or seasonal part-time job, doing miscellaneous chores such as dog walking for a fee, participating in focus groups, and selling items at garage sales or online. Tightening the budget and cutting spending on nonessentials for several months can also produce sufficient money for an emergency fund.

An emergency fund can be kept anywhere, but it needs to be liquid and readily accessible. The best practice would be for an individual to keep the money in a checking, savings, or money market account that is insured by the Federal Deposit Insurance Corporation (FDIC). Ideally, an interest-bearing account is desirable as long as there are no penalties or fees for withdrawals. Individuals should avoid getting an ATM card with the account, as the convenience of the card would increase the temptation and opportunities to withdraw money for regular expenses.

Keeping emergency funds separate from funds used for everyday expenses is crucial. When emergency funds are combined with funds for household expenses, it is too easy for most people to view the emergency fund as extra money that can be spent. Many individuals find it best to keep the funds in a bank other than their primary one to prevent temptations. In some cases, an online bank could serve as an alternative. Reserving a large sum of money in an account with low or no interest may seem counterproductive when investing the money in stocks or mutual funds can generate more interest. Those investments, however, are not readily accessible should funds be needed, and early withdrawals may result in penalties and fees that may negate any interest advantage.

Having an emergency fund can diminish the impact of income loss and unexpected expenses. Without an emergency fund, individuals faced with fortuitous events may be forced to make last-resort decisions, such as moving in with family members or friends or taking out high-interest loans. With an emergency fund, individuals can continue their customary lifestyles or make changes without undue pressure and stress. When emergencies do arise, they can be met with the resources to handle them.

Bibliography

Bennett, Karen, and Marc Wojno. "Survey: 62% of Americans Feel Behind on Emergency Savings, While Only 1 in 5 Has Increased Savings This Year." Bank Rate, 23 Oct. 2024, www.bankrate.com/banking/savings/emergency-savings-survey. Accessed 23 Dec. 2024.

Chase, Stephanie, et al. "Coming Up with Cash in a Pinch: Emergency Savings and Its Alternatives." Center for Financial Security, University of Wisconsin–Madison, June 2011, cfs.wisc.edu/wp-content/uploads/2011/06/2011-coming-up-with-cash-in-a-pinch.pdf. Accessed 23 Dec. 2024.

Cruze, Rachel. "Emergency Fund: Why You Need One and How Much to Save." Ramsey Solutions, 19 Nov. 2024, www.ramseysolutions.com/saving/quick-guide-to-your-emergency-fund. Accessed 23 Dec. 2024.

"How to Build an Emergency Fund." Investopedia, 20 Dec. 2024, www.investopedia.com/personal-finance/how-to-build-emergency-fund. Accessed 23 Dec. 2024.

"How to Build an Emergency Fund." PNC Insights, 9 July 2024, www.pnc.com/insights/personal-finance/save/how-to-build-emergency-fund.html. Accessed 23 Dec. 2024.

Nesta, Adrian, and Hiranmayi Srinivasan. "Your Household Should Have at Least $33,000 in an Emergency Fund." Investopedia, 7 Aug. 2024, www.investopedia.com/average-household-should-have-at-least-33000-in-an-emergency-fund-8653957. Accessed 23 Dec. 2024.

"Saving for an Emergency." Wells Fargo, www.wellsfargo.com/financial-education/basic-finances/manage-money/cashflow-savings/emergencies. Accessed 23 Dec. 2024.