How to Set up Emergency Funds & Prepare for Potential Financial Risks in Five Easy Steps
by Scott K. Schmidt, Chief Financial Officer, U.S. Money Reserve
Preparing for the unexpected is key to the security of your financial future. Here’s what you need to know to help set up an emergency fund.
Creating a plan for the worst of times may sound counterintuitive to other financial goals you may have, like buying a house or saving for your child’s college fund. In truth, one of the most important first steps toward those goals is to ensure that you have an emergency fund set up. In fact, most financial planners and experts recommend saving for a rainy day before moving on to your more significant and more ambitious goals and plans.
The sad truth is that 21 percent of Americans say they don’t have an emergency fund, according to a Bankrate study from mid-2020. What’s even worse is that as of January 2021, a second survey, also done by Bankrate but in December of last year, shows that fewer than four in ten Americans have enough money set aside to cover an unexpected expense of just $1,000. Those are alarming numbers and really drive home just how important having an emergency fund is.
Considering those facts, here are five easy steps to take to help set up an emergency fund and prepare for potential financial risks.
Understand How Much You Need to Put Away
The first step to establishing an emergency fund is to understand just how much you need to put away. That number can and does vary from both year to year and situation to situation. The general (and best) rule of thumb is to plan to put away enough to cover between three and six months of household bills. The higher your household bills, the more money you’ll need to put away.
The critical thing to understand about your emergency fund is that it should only be used for emergency situations. But what constitutes an emergency situation? Say a natural disaster strikes your area, and you need to secure a place to stay while your home is being repaired or while you wait for your insurance claim to come through. What if you lose your job and need some time to get back on your feet? You can use your emergency fund for that as well. What if you get sick and need to cover the cost of medical bills? That’s what your emergency fund is for! Essentially an emergency fund covers unexpected bills that arise as a result of a surprise event in your life. An emergency event is generally not something you can plan for specifically, but you can set you and your family up to be secure if and when something unexpected happens in your life.
Figure out What Your Household Expenses Look Like
In order to decide on your specific savings goal amount, you need to get a handle on just what your household expenses look like on a monthly basis. That means you need a budget. I have written extensively about creating a budget and understanding how to help ensure that you and your family are financially stable going forward. You can read more of that story here.
What exactly constitute household expenses? Things like housing, food, utilities, your cell phone, internet connection, transportation, insurance, and other essential items must be maintained. Once you have a monthly budget in place and understand the total costs of all these items, you can begin to figure out just how much money you need to set aside for your emergency fund. Remember that you’ll need to adjust your emergency fund to ensure that any possible increases are accounted for and covered if you increase your household expenses. If you move into a larger home, decide to upgrade your vehicle, or change your insurance, your monthly household expenditures will change, and you’ll need to adjust your emergency fund accordingly.
Set the Right Goals
Once you’ve figured out how much to save, you’ll need to set some regular monthly goals to aim for so that you know you are on the right track. At first, it might seem like a lot of money to put into a fund you may never need, but the truth is that having the cash to be able to rescue yourself and your family if needed is really vital to making sure you are financially secure. The sooner you can shore up your emergency fund, the sooner you can move on to saving for other goals.
While it can seem daunting to try and save up to six months of household expenses, the best thing to do is start small and gradually work your way up. For example, you could start by aiming to save just $1,000 at first. Then perhaps step up to $2,500 and then $5,000, working your way up the ladder until you reach your goal. This helps leverage positive reinforcement psychology and will help you stay on track for the long term. By celebrating the little wins along the way, you can ensure that you will achieve your emergency fund goals in no time.
One quick word about prioritizing your financial goals: Financial experts differ on whether you should focus on one financial goal at a time or try and save for multiple goals all at once. It really depends on the approach that works for you and your family. Most experts recommend focusing on one goal at a time so that you can start to tick off the necessities and gradually focus on saving for more things as you go. Having an emergency fund is a top priority to ensure your financial security, and it’s often the first thing that experts recommend focusing on. Once you know you can cover an unexpected emergency, then you can start to focus on things like saving for a home, vacation, or your children’s college tuition.
Save Your Windfalls
A great way to quickly accelerate your savings is to put away any unexpected windfalls you might get. Income such as bonuses, an inheritance, or unexpected sales can really fast-track your emergency fund savings. You can choose to set aside a portion of these windfalls — or all of them — to help boost your emergency savings.
Create an Automatic Savings Plan
Another sure way to accelerate saving for a rainy day is to create an automatic savings plan. Essentially the idea is to put away a set portion of each check you receive each pay period. You can set this up through your payroll system with HR, which will essentially take a designated portion of your pay and place it directly into another account without your having to worry about doing it manually. It’s kind of like a 401(k) plan (minus the tax benefits) for emergency savings.
You can set this type of plan up a few different ways, but in my opinion, the best way to execute this is to set up a separate account to house your emergency savings. It can really help accelerate your savings if you choose a high-interest savings account. You can also choose to put your emergency fund into a money market account or a CD account, though most payroll systems require automatic savings to go to a bank account. If you choose a money market or CD account, you’ll need to put the money into those types of accounts manually rather than automatically.
The idea behind an automatic savings plan is that if you put aside a set amount each pay period, without having to think about it, you can reduce your urge to spend that cash on something else. Plus, you ensure that you are making consistent and steady movement toward your emergency savings goal.
The Bottom Line on Saving for a Rainy Day
While it may seem like an overwhelming task to save a big chunk of cash for an emergency, it can pay tremendous dividends should something go wrong. Setting aside an emergency fund is a critical part of creating a solid foundation for your financial security. It’s a lot like having health insurance or homeowner’s insurance — you hope to not need it (or not need it very frequently), but it’s there when you do need it, and it can help you save a boatload in the long term. Remember, the main goal of an emergency fund is security, not return. It’s foundational and can help protect you and your family from possible financially painful issues down the road.
