The COVID-19 pandemic has really demonstrated the reasoning behind why savings are important and left many wondering how to start an emergency fund of their own. With many put out of work or with significantly less income, financial security is more important now than ever before.

This pandemic isn’t the only reason an adequate emergency fund is critical. There are lots of reasons to have an emergency fund including unexpected medical issues or home repairs, loss of income or job, and car accident.

If you’re looking for a guide to getting your emergency fund started, funding it adequately, and maintaining it, you’re in the right place. Here’s how to start an emergency fund (and tips for how to maintain it long-term as well).

Why are emergency funds important?

Life happens. It is a fact. We cannot anticipate everything that will happen in the future. This is why Dr. Thia suggests there is no such thing as the perfect financial plan. 

The COVID-19 pandemic is living proof. Some reading this may have battled cancer or likely know someone who has. That was not planned.

We had a water leak from our bathroom on the second floor a few months ago; we certainly didn’t see that one coming. Let me tell you, if we had we would have stopped it! It was a pain to deal with.

Let’s use a sports analogy for fun. When a quarterback throws a pass downfield, they typically try to get the ball to the receiver in stride. This allows the receiver to maintain momentum towards the end zone.  

The way to handle financial emergencies in stride is through having emergency funds. 

When life happens, we need money to fall back on so we don’t accumulate expensive debt that is hard to get out from under. That’s why emergency funds are important. We need emergency funds so that our day-to-day financial plan isn’t derailed. We need emergency funds so we don’t have to worry. 

Simply put: An emergency fund is peace of mind. 

Emergency savings plans are so critical that I would argue other financial goals (saving for a car, vacation, etc.) should be put on hold until an adequate emergency fund is established. The one caveat to this is for those with an employer who offers a match on the employer-sponsored retirement account. Don’t miss out on this free money! 

So, now that you understand and are on board with having adequate emergency funds. Here is where to start. 

How to start an emergency fund

Open an account

Emergency funds should be held in an account designated for this sole purpose. This is both for record keeping, to ensure the emergency fund is adequately funded, and to psychologically separate the funds from your day-to-day finances. 

The funds need to be easily accessible, and that’s why the rule of thumb in personal finance is to have the funds in a savings account held at a bank or credit union.

Likely, opening a savings account at the same bank or credit union as your main checking may be the most convenient choice. This allows you to see your accounts in one place and easily transfer money from checking to savings and opening the account is typically simple due to the existing relationship. 

However, there are a couple of reasons to consider other institutions. If having the funds accessible is tempting to you, another institution may be appealing. Also, know that interest rates in savings accounts vary from one institution to the next, so it may behoove you to shop around a bit to maximize interest earned as emergency fund accounts should hold more than change. 

Figure out how much you should save

Once you have an account open, now you need to figure out how much you should save in your emergency fund. Recent history has changed the answer to this question. 

Well, when I was in college (2005-2009) the answer was a clear and emphatic three months of living expenses (I.e. what you need to pay three months of bills and have the essentials like food, gas, etc.). Once the Great Recession hit — right as I was exiting college — the answer changed to six months of living expenses. 

Today, the answer is somewhere between the two. Where you fall in the range of three to six months depends on your risk tolerance, your career and income, what your health is like, and any other personal circumstances you think are relevant. 

Putting more than six months of expenses in an emergency fund likely is not in your best interest. More than six months of living expenses in the emergency fund is unnecessary and could better be used elsewhere, like investments or retirement plans.

Spending power risk comes into play if you have too much money in a savings account. Interest rates on savings accounts are extremely low. So, other types of accounts, such as investment accounts, are likely a better fit once three to six months of living expenses is saved. 

Plus, if a long term, more serious emergency occurs, you can always use the funds that are earmarked for other goals and wants as necessary, without having to specifically allocate them to your emergency fund. 

Find places to cut your spending

Now it’s time to fund the account and work up to the goal amount. This can feel daunting, but it doesn’t have to be. Think of it as a puzzle that needs to be pieced together. 

Give yourself a year to get your goal amount saved. Do this by moving the amount of money needed every payday to get to your goal (called paying yourself first.) For example, people who happen to get a bonus at work could use this to put a big dent in saving for the goal or perhaps even to reach the goal. 

If you don’t have enough to put in each payday to reach your goal, look at your spending and see what you can cut out. 

Elizabeth Warren, a bankruptcy expert and US Senator, coined using a 50/30/20 approach to saving. Basically, she concludes that putting 20% of our after-tax income towards our financial goals is critical. If you’re spending more than 50% of your after-tax income on needs (paying for housing, a reliable car, etc.), and/or more than 30% on wants, she suggests changes need to be made. 

Tracking expenses is critical and eye-opening when people live paycheck-to-paycheck, or when money seems to dry up faster than we expect. This is why we include the opportunity to do so in both Richer Retirement and MPowered Couple

The other thing to do is increase income. Get a part-time job until the account is funded, or get a one-time season job that will pay the amount needed. Important, though, is that the added income not be used for other spending until the goal of funding an emergency account is reached.

How to maintain an adequate emergency fund 

It takes hard work to build up an adequate emergency fund but it takes grit to maintain it! 

Divert funds for other goals

It is inevitable that life will happen. It is ok to use emergency funds when needed. But just as important is building the funds back up after, so that when life happens again there is a safety net. 

The best thing is that if you can build the account back up with cash flow (through paying yourself first) over the following couple or few months. 

If that isn’t a reality then divert funds that would have been going to other financial goals — a car fund, a vacation fund, a fund for a second house, etc — to re-establishing your goal emergency fund amount. 

Remember: Emergency funds are for emergencies only 

The final thing to say about emergency funds is this. The money is for emergencies only. It is not for shopping at a favorite store that happens to have a great deal going on. It’s not for buying Christmas gifts or for paying a deposit on an upcoming vacation that is planned. 

Seek professional support

Emergency funds are one foundation block to a good financial plan. If you are ready to think about your financial plan from a more holistic perspective, learn more about our financial courses. 

Richer Retirement is a course for individuals wanting to live a more positive, financially secure life from today on into the golden years. MPowered Couple is a course for committed couples wanting to build a strong financial foundation within their relationship. We hope to see you in class soon!