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How much should you save to cover your next emergency?

February 01, 2021
Building emergency savings blog cover

The current COVID-19 pandemic has dried up a large number of savings accounts, leaving many Americans heavily in debt. The reality, however, is that many of these financial problems existed long before the healthcare crisis spotlighted the fragility of Americans' savings habits. 

Research by George Washington University, funded by the National Endowment for Financial Education confirmed that 36% of American households are "financially fragile" and could not come up with $2,000 in 30 days (even before the pandemic struck).

Emergency savings are critical for handling unexpected situations and expenses so that little problems don't become major setbacks. Most financial experts suggest setting enough money aside to cover three-to-six-months' worth of living expenses. Exactly how many months of living expenses you need to save depends on the amount of difficulty you'll face in recovering lost income. Salaried individuals with somewhat stable jobs, for example, may only need three months of expenses saved, whereas hourly employees with more variable income may need at least six months' worth. 

When calculating how much you need to save, be sure to consider the following monthly expenses:

  • Rent/mortgage payment
  • Utilities (gas, electric, water, and trash removal)
  • Telecom payments (phone, cable, and internet)
  • Insurance payments (car, health, and home)
  • Transportation costs (car payments, gas, and/or public transportation costs)
  • Debt payments (credit cards, student loans, and all other loans except for mortgages)
  • Grocery expenses
  • Other (childcare, alimony, real estate taxes, etc.)

Why an emergency fund is a good idea

Even when there's not a pandemic creating financial havoc, there are many reasons to have an emergency fund. Some of the more common "rainy day" scenarios include:

  • Unexpected medical expenses. Although you might do your best to lead a healthy lifestyle, accidents and illnesses still happen.
  • Car repairs. Beyond regular maintenance (which, by itself, can be costly), cars are expensive to drive and tend to break down at the most inconvenient times, creating hundreds and thousands of dollars in bills.
  • Job loss. Employment can be terminated in good and bad economies. Unfortunately, many people accumulate financial obligations that often require full-time work; or, for both spouses to be employed full-time, if you're living in a two-income household. If one spouse becomes unexpectedly unemployed, it can create a major financial shortfall. 
  • Major home repairs. As is the case with automobiles, home repairs often become necessary at the worst times when you can least afford them. A broken furnace, leaky roof, or dry well top the list of most expensive home repairs. But plumbing problems, cracks in the foundation causing a wet basement, and a malfunctioning central AC system are also costly repairs. 

Although these represent some of the more frequently cited reasons that people drain their emergency funds, this is by no means an all-inclusive list. Less common, be equally financially devastating, are identity theft situations which preclude access to any and all credit lines; IRS audits resulting in back taxes (with penalties) being owed; required travel expenses incurred to care for an out-of-state relative or friend; and legal liabilities from an array of possible lawsuits. 

Other ways to cover unexpected expenses

Of course an emergency savings account isn't the only way to cover these expenses. You could, instead, tap requirement accounts, liquidate investments, or access credit lines, if you're fortunate enough to have any or all of these. But these options all come with significant drawbacks.

Using retirement funds, for example, could incur a penalty if you're not old enough. Even without a penalty, there will be added tax liability for withdrawing from a retirement account. If you're forced to quickly sell an investment, you may suffer a financial loss or, at best, incur an added tax liability if you realize a gain from the sale. Financing an emergency with a credit card or line of credit simply pushes your debt into the future. It doesn't solve the problem and actually increases the total cost as a result of incurred interest.

How to create an emergency fund

1. Be realistic and build slowly. If you don't currently have an emergency fund, don't expect to have what you need overnight as that will lead to discouragement. Start by allocating a small percentage of your income each month. Even $50 a month (which is slightly more than $10 per week) can make a difference over time. Financial experts, however, suggest targeting 15% of your income for savings.

2. Set short-term and long-term goals. Start by establishing where you want to be in six months and then create a long-term schedule for how you will reach your ultimate goal of covering three-to-six months' worth of living expenses.

3. Track where your money is going. Many people have no idea how much they spend each month beyond covering the basics. Today there are numerous mobile banking and budgeting apps to help track and manage your money. Once you see where your money is being spent, you'll be in a better position to identify realistic options for cutting expenses.

4. Automate contributions. It's easier to save money that you never see. Work with your employer to create automatic deductions that transfer a specified amount from your paycheck to your emergency fund.

5. Deposit all extra money. There may be many times throughout the year that you find yourself with extra money. It may be in the form of a raise or a bonus at work. Perhaps it's a tax refund or a cash birthday gift. Whatever it is, make sure all such "found" money goes straight into your emergency fund rather than spending it on discretionary purchases. 

6. Accumulate funds in a liquid interest-bearing account. Liquidity is important as you never know when an emergency will come up that demands extra cash. While it's also important  to have longer-term investments, such as 401(k) contributions, traditional or Roth IRA accounts, etc., for emergency purposes you need an account that provides immediate access without incurring a penalty. And be sure to compare interest rates. Even a fraction of a percent can make a difference in the long-term as you watch your money accumulate and grow. 

Creating an adequate emergency fund not only makes sense for your financial health, but can also eliminate a lot of stress caused by unexpected expenses to improve your physical health. Make the healthy choice and start (or build) your emergency fund today.

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