What Is an Emergency Fund?

The term emergency fund refers to money stashed away that people can use in times of financial distress. The purpose of an emergency fund is to improve financial security by creating a safety net that can be used to meet emergency expenses, such as an illness or major home repairs. Assets in an emergency fund tend to be cash or other highly liquid assets. This reduces the need to either draw from high-interest debt options, such as credit cards or unsecured loans, or the need to undermine your future security by tapping into retirement funds.

Key Takeaways

  • An emergency fund is a financial safety net for future mishaps and/or unexpected expenses.
  • Emergency funds should typically have three to six months' worth of expenses.
  • Individuals should keep their emergency funds in accounts that are easily accessible and easily liquidated.
  • Savers can use tax refunds and other windfalls to build up their funds.

Understanding Emergency Funds

As mentioned above, an emergency fund is established when an individual puts away money that is intended to be used during times of financial hardship. This includes the loss of a job, a debilitating illness, a major repair to home or car, not to mention the kind of major national crisis the coronavirus pandemic created following the outbreak in 2020.

The size of your emergency fund depends on a number of factors including your financial situation, expenses, lifestyle, and debts. According to most financial experts, you should be able to cover anywhere between three to six months’ worth of expenses.

It may be tempting to use your fund for incidental or frivolous purposes, so make sure you don't deplete this resource for any other purpose other than an actual emergency.

Starting early is the 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 one:

  • Set aside a comfortable amount from your salary each month. Calculate your living expenses for the desired period and make that your target for an emergency fund. You can then divert a portion of your paycheck—perhaps by setting up an automatic transfer—to that account each month. Once the fund is built up, 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 an 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.

As previously noted, you should consider putting money for an emergency fund into a vehicle that is easily accessible and can be easily liquidated. For instance, consider putting your money away in a high-interest savings account or a money market account. These accounts allow you the access you'll need in an emergency and also prevent you from incurring fees and time delays associated with other vehicles like brokerage accounts. More on this below.

Special Considerations

You should consider building an emergency fund before venturing into 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, as the coronavirus crisis made vividly clear. Should that be the moment you need to tap them, you could lose more value. An emergency fund protects your portfolio against that risk.

While storing cash in a 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.

Research shows most Americans aren't prepared for an unexpected expense of just $400, let alone for an emergency. In fact, a 2019 survey by the Federal Reserve found that:

  • 61% of Americans had the ability to cover a $400 expense with cash, savings, or a credit card
  • 27% would have to resort to borrowing or selling personal items to cover that expense
  • 12% would not be prepared to cover that expense at all

Helping Employees Save

A number of major employers introduced programs encouraging emergency savings because of the effects of financial instability on productivity and retirement security. The following is a list of programs offered by some major companies for their employees:

  • SunTrust: The Momentum onUp Program offers $1,000 to employees who complete an eight-part financial education program, then open and fund an emergency savings account. More than 11,000 graduated as of July 2019, according to Tom Crosson of SunTrust, in an email interview.
  • Levi Strauss: The apparel brand gives hourly employees up to $240 in matching funds through its Red Tab Foundation when they make qualifying contributions to their savings accounts over a six-month period.
  • Prudential: The financial services firm began offering a feature within its workplace retirement plans allowing employees to divert part of their paycheck toward a savings account. This program was launched by the company in 2018.

Example of an Emergency Fund

Here's a hypothetical example to show how emergency funds work. Let's say a married couple has monthly expenses totaling $5,000. This includes the couple's mortgage payments, food bills, car payments, and other necessary outlays. Using the three-month rule, the couple needs to set aside at least $15,000 (or $30,000 for six months) to address any unexpected financial burdens.

The funds are typically held in the form of highly liquid assets, such as checking or savings accounts. These vehicles allow quick access to cash to pay expenses during an emergency situation.