What Is an Emergency Fund?
An emergency fund is a readily available source of assets to help one navigate financial dilemmas such as the loss of a job, a debilitating illness, or a major repair to your home or car. The purpose of the fund is to improve financial security by creating a safety net of cash or other highly liquid assets that can be used to meet emergency expenses, as well as reduce the need to draw from high-interest debt options, such as credit cards or unsecured loans—or undermine your future security by tapping retirement funds.
Understanding Emergency Funds
An emergency fund should contain enough money to cover between three and six months’ worth of expenses, according to most financial planners. Note that financial institutions do not carry accounts labeled as emergency funds. Rather, the onus falls on an individual to set up this type of account and earmark it as capital reserved for personal financial crises.
- An emergency fund is a financial safety net for future mishaps and/or unexpected expenses.
- Financial planners recommend that emergency funds should typically have three to six months' worth of expenses in the form of highly liquid assets.
- Savers can use tax refunds and other windfalls to build up their fund.
A married couple with expenses totaling $5,000 a month—including mortgage payments, food, car payments, and other necessary outlays—would need to set aside at least $15,000 (three months) and as much as $30,000 (six months) to address unexpected financial burdens. The funds are typically held in the form of highly liquid assets, such as FDIC-insured checking or savings accounts. These vehicles allow quick access to cash to pay expenses during an emergency situation.
Emergency Funds and Investing
Individuals should consider building an emergency fund before venturing into more volatile investment vehicles such as stocks. Whereas the latter offer greater long-term growth potential than cash and cash equivalents, their value can suddenly decrease in the event of an economic downturn. Should that be the moment you need to tap them—and people do tend to, say, lose their jobs in a financial crisis—you could lose more value than you need to. An emergency fund protects your portfolio against that risk.
According to the Federal Reserve, 39% of Americans wouldn’t be able to pay for an unplanned $400 expense with cash or savings.
While storing cash in an FDIC-insured bank account may be the safest approach, there are other relatively secure ways to store a part of your emergency fund that offer greater interest-earning potential. These include money market accounts or no-penalty certificates of deposit (CDs), which don’t charge savers a fee if they need to pull their money out before the maturity date.
Prudent advice should deter a new investor from immediately placing savings in an investment vehicle, such as a growth mutual fund, before that individual creates sufficient liquid capital on which to rely in the event of income loss. Growth funds, while less volatile than individual stocks, hold risk to principal that is best mitigated by increased time horizons. Furthermore, managed growth funds often charge a front-end sales load of up to 5.75% or a contingent deferred sales charge (CDSC) against redemptions that would further impact principal needed in the event of an emergency.
Helping Employees Save
Research suggests that much of the population is well short of the common three-to-six-months target for emergency funds. For example, a 2019 survey by the Federal Reserve found that nearly four in 10 Americans wouldn’t be able to pay an unexpected expense of just $400 with cash or savings.
Concerned about the effects of this financial instability on productivity and retirement security, several major employers have recently introduced programs that encourage emergency savings—and there's a savings plan bill in the Senate, as well.
SunTrust's Education Program
SunTrust Banks, for instance, is offering employees $1,000 if they complete an eight-part financial education program that covers basic topics like budgeting, insurance and investing, and open and fund an emergency savings account. More than 11,000 have graduated, according to Tom Crosson of SunTrust.
Levi Strauss Matching Funds
Through its Red Tab Foundation, the apparel brand Levi Strauss & Co. gives hourly employees up to $240 in matching funds over a six-month period when they make qualifying contributions to a savings account. If they save enough for all six months to qualify for the full match, they get a $20 bonus and end up with a $500 savings account.
Prudential Retirement-Plan Feature
Meanwhile, the financial services firm Prudential began offering a feature within its workplace retirement plans that allows employees to divert part of their paycheck toward a savings account. “A small additional contribution each pay period may help build a financial cushion and reduce the effects of 401(k) plan withdrawals and loans that may cut into employees’ retirement savings and increase workforce costs for employers,” Phil Waldeck, president of Prudential Retirement, said in a statement announcing the program in 2018.
A bipartisan bill introduced earlier this year in the Senate would go a step further, allowing employers to set up emergency savings vehicles funded by automatic payroll deductions. Under the “Strengthening Financial Security Through Short-Term Savings Accounts Act of 2019,” workers would have to opt out if they chose not to participate.
2 Strategies to Set Up an Emergency Fund
Starting early is key to setting up an emergency fund, because it helps you build up a comfortable cushion against unexpected emergencies later in life. Getting a start on emergency funds is relatively easy. Here are two simple ways to begin saving for an emergency fund:
- Set aside a comfortable amount from your salary each month. Calculate your living expenses for at least three months and make that your target for an emergency fund. You can then divert a portion of your paycheck—perhaps by setting up an electronic withdrawal—to that account each month. Once the fund is built up to the level you need, invest extra savings for the long term or for other goals, such as the down payment on a mortgage.Once you've maxed out your retirement savings, that money could go into a investment account, with higher risks and rewards.
- When you get your tax refund, save it. The tendency for most of us is to consider a tax refund as “extra” cash, which consumers may be tempted to use for discretionary purchases. Instead of spending the tax refund, save it as a contribution toward your emergency fund.