As a frequent visitor of many personal finance forums, I’ve noticed one glaring question that definitely gets asked more than anything else: “Now that I can put money into savings, how do I juggle an emergency fund along with my other financial goals?” See my recommended approach to prioritizing your emergency funds when you have other goals to save for.
I commend anyone who asks this question because it shows that they are serious about improving their finances — unlike the 33 percent of Americans who actually choose not to build an emergency fund even though they have money left over at the end of every month.
It’s a common concern by people of all ages, from young graduates who just got their first jobs to middle-aged folks who just climbed out of debt.
You know that an emergency fund is an essential part of your financial setup. But, understandably, you are also thinking about saving for other things like vacations, a car, your first home, retirement and more. Despite how great those things sound, an emergency fund should be your absolute top priority — after bills of course.
Where to put your emergency fund
Setting up a proper savings account is the first step in building an emergency fund.
An emergency fund should be held in cash in a bank account that is easily accessible. Use a savings or money market account to play this role. Personally, I use my Ally money market account as my emergency fund. But any online savings account would be perfect as an emergency fund.
Ally Bank’s savings account has no monthly fees and offers a very competitive savings rate. Synchrony Bank has an online savings account with a $3 monthly fee that is easily avoided with just a $30 balance — and it happens to have one of the best savings rates available.
Caution: Your credit card and 401(k) loans should not be considered emergency funds. Both will come with high interest rates and/or high penalties.
Here’s how to prioritize your emergency fund
Here is the order in which you should allocate your income every month and how you should build your emergency fund.
1. Pay for rent, utilities and food
These are your basic necessities that you require for survival, so they must come first. In 2014, the average U.S. household spent a total of $1,733.42 on these expenses.
2. Make just the minimum payments on your debt
You are going to make the smallest payments possible to avoid incurring expensive late payment fees and penalties on your credit cards and loans. If you focused on paying down this debt, it would take much longer to build an emergency fund because you’re going to keep spending (aka racking up debt).
3. Build an emergency fund equal to three to six months of necessary expenses (total cost of #1)
The emergency fund is used to cover unexpected expenses during situations such as job loss, serious illness or car breakdowns. The emergency fund for an average household should be $5,200 to $10,400.
Alternative: Personal finance gurus suggest that you first create a smaller emergency fund (of around $1,000 – $2,000) and the complete Step 4 before fully completing the rest of your emergency fund.
4. Contribute the minimum to your 401(k) plan to get a match
The employer match on your 401(k) plan is often considered “free money.” For example, if you get a 3 percent company match on your $50,000 annual salary, contribute at least $1,500 to get the full company match of $1,500.
5. Pay down all debt with APRs of 8 percent or more
You want to pay off debt (such as credit card balances) that has APRs of 8 percent or more. The reason being, a diversified investment portfolio has historically averaged an 8 percent return, so paying off this debt is guaranteed to save you more money than the money you’d possibly earn from investments.
6. Fully fund your 401(k) plan
If you like your 401(k) plan and the investment choices offered to you, max it out. In 2015, the contribution limit is $18,000 (the contribution limit is $24,000 if you are age 50 and older).
7. Fully fund your traditional and/or Roth IRAs
Once you’ve fully funded your 401(k) plan (or if you don’t have one), max out your IRA contributions, which is $5,500 for 2015 ($6,500 if you are age 50 and older).
8. Save for other financial milestones (i.e., car, wedding, house, etc.)
With your necessities covered, rainy-day fund prepared, debt paid off and retirement secured, you’re ready to move onto your other savings goals.
Have you ever had to tap your emergency fund to pay for a surprise expense? If so, what was the situation and was your emergency fund enough to cover the cost?