How do I build an emergency fund?
Deep down, almost intuitively, most people know they need an emergency fund. Random, expensive crap happens more frequently than most of us want to admit, and we know that we need to have a plan for it. But building an emergency fund can be a little intimidating for a couple of reasons – most people don’t know where to start, and the overall task seems overwhelming.
So let’s answer those questions to get you moving towards building a properly-sized emergency fund.
When we talk about where to construct an emergency fund, banks are where you should turn to first. Two of the key characteristics that an emergency fund needs to have are liquidity and stability. Banks provide you with both. You put your money in, you earn a low interest rate, but you effectively don’t have any chance at losing money because of volatility. What you put into the bank is guaranteed through FDIC insurance to be there tomorrow. So while the returns on bank accounts are often lower than stocks over extended periods of time, bank accounts provide significantly more stability than stocks over just about every period of time. Bank accounts also give you the ability to withdraw money at any time through ATMs, though you may see daily withdrawal limits through that method. However, your full account balance is typically accessible by seeing a teller during the hours they are open, giving you access to the full balance in your emergency fund during most normal business hours.
Another question people tend to have when it comes to constructing an emergency fund is where to prioritize it in your budget. Should retirement come first? What about paying off debt? What about other investments? I have seen all kinds of different thoughts concerning this. Some people say to prioritize retirement first, some people say to put your emergency fund first, some people say to pay off credit cards first. There is no consistency out there, so I’m going to add to it since it suggests there is no true right answer for every situation, and maybe my thoughts are what you need for your situation.
Getting that first $500 into your emergency fund has to be your first priority, because it helps to prevent all kinds of other bad things from happening. Having $500 in a bank account can keep you from having to turn to payday loans and credit cards to cover emergencies. These options usually have very high interest rates, and can get you trapped in a cycle of paying a ton of interest for an extended period of time. So get your $500 put away first. From there, your next priority should be getting rid of high-interest credit card debt as quickly as possible. Interest rates on credit cards regularly exceed 20 percent, which is realistically higher than you can expect to return on any asset you invest in. So once you have your $500 put away in your emergency fund, work on tackling your credit card debt problem. If you don’t have one, first be thankful for the situation you’ve been able to end up in, and second, start saving money for retirement. While it’s great to build up an emergency fund, the rates of return generated there are often minimal compared to the investments you can find in retirement accounts. And the real power of retirement savings happens when you start early and give the returns a chance to compound over a long period of time. In addition, your employer may offer matching contributions for your retirement account, so make sure you take care of those. It’s basically free money.
Once you are making the minimum contribution required to get the full match from your employer, then you need to start building additional emergency fund savings into your budget. Even starting as low as $10 per week helps to get you another $500 put away for another emergency over the course of the year, so start small and build the habit. But I think a good frame of reference is that when you look at your cash flow for the month after getting matching retirement contributions, aim to get 20 percent of your free cash flow into an emergency fund to build it quickly enough.
Here’s what the math would look like:
- Suppose you have $500 in free cash flow after all expenses, but not before retirement, and your credit card debt is paid off
- Your match requires you to contribute $300 per month to get the full match
- Contribute $300 to retirement for the month, leaving you with $200 in free cash flow remaining
- Take 20 percent of that free cash flow, or $40 per month, and put it into your emergency fund, with the remaining $160 going to retirement
This should give you a solid framework as you begin to build an emergency fund. If you get a raise and your free cash flow improves, it could allow you to make bigger contributions to your retirement and emergency funds. Don’t expect to have this built up to the perfect level overnight. It may take several years to get to the point where you have a stable and good-sized emergency fund. But it all starts one step at a time, and starting is the biggest thing you can do to get moving in the right direction.