Why You Should Make an Emergency Fund a Priority
Picture yourself relaxing on vacation at your favorite travel destination.
However, before your temporary escape from a hectic life, you have to plan that vacation.
You spend hours looking up hotels, places to eat and things to do but it doesn’t feel like work because the anticipation of this trip makes you feel happy.
Unfortunately, we’re not putting the same level of effort for major financial necessities, especially for something as important as an emergency fund. Shockingly, according to The National Foundation for Credit Counseling, 64 percent of Americans don’t even have $1,000 in their savings to cover an unexpected event, such as an emergency room visit.
It’s understandable -- no one looks forward to emergency situations that would cost a ton of money.
So, we’re less likely to build an emergency fund even if we have the money to do things like go on vacation. In fact, many Americans actually choose not to build an emergency fund even though they have the financial wiggle room to do so.
According to Dr. Michaela Pagel, the Roderick H. Cushman Professor of Business at the Columbia Business School, building an emergency fund is often a question of discipline. "People may want to build emergency savings but do not because they have self-control problems with respect to their spending, i.e., they buy too much stuff today instead of saving more tomorrow," explains Dr. Pagel.
Fortunately, the power to change that mentality is within our grasp. Learn why an emergency fund is critical and how you can save for an emergency fund without a lot of thinking or effort.
What exactly is an emergency fund?
An emergency fund is money that is saved up for the purpose of covering the costs of unexpected situations such as a sudden illness, loss of income or car repair.
As if an emergency isn’t scary enough, the majority of bankruptcies in America are actually caused by medical bills. Having this fund will prevent a financial emergency from becoming a financial disaster.
The most common question is: how big should your emergency fund be? Generally, it should be equivalent to 3 to 6 months worth of living expenses, which includes housing, utilities and food.
For example, if your monthly living expenses total $2,000, your emergency fund should have $6,000 to $12,000 in it.
To give you an idea of how long it would take to build a $6,000 emergency fund, check out the table below:
How Long It Takes to Build a $6,000 Emergency Fund
| Monthly Savings | Emergency Fund Goal | Months to Complete Goal |
|---|---|---|
| $200 | $6,000 | 30 months |
| $400 | $6,000 | 15 months |
| $1,000 | $6,000 | 6 months |
Obviously, the more you can funnel into emergency savings, the sooner that you’ll have that financial buffer. (If you already have some money in savings, then congratulations on getting a headstart on your emergency fund.)
Contribute to your emergency fund without thinking about it
Frankly, we know it is tough to make it enjoyable to create an emergency fund. Remember, emergency funds take some time to set up. If you’re dragging your feet, automate your finances.
Pick an online savings account. Go with online savings account for higher interest rates, plus most of them don’t have monthly fees.
Once you've opened an account, a key is to make funding it as automatic as possible. Columbia's Dr. Pagel stresses the importance of removing the temptation to spend money as it comes in.
The number one tip I have is: take money out of the checking account and transfer it to a savings account at the beginning of the month (after the paycheck has been deposited). This way the money is not burning a hole into your pocket but is stashed away for savings (and you can maintain a rule to not touch it). Many studies show that people spend when they have cash.
When you’ve established your emergency fund, it doesn’t mean you should stop saving.
Go ahead and use the same method for all your other savings goals.
Tip: try separate automatic transfers for each individual goal.
(We know that online banks like Ally Bank and Capital One 360 let you create multiple savings accounts, so you can nickname each account for each goal.)
Building an emergency fund is just the beginning.
By eliminating much of the work required to save every month, you’ll eventually discover that it isn’t all too hard to stay focused on your financial goals.
How to prioritize your emergency fund when money is tight
Many people are understandably confused as to how they should prioritize their emergency funds when they also have to consider other financial obligations, such saving for retirement and paying down debt.
We believe that an emergency fund is the absolute #1 priority. Without an emergency fund, you’re going to have to borrow money to pay for an emergency and end up interest payments that will likely keep you in debt.
Therefore, after you’ve paid the necessary monthly bills and minimum payments to your credit cards and loans, start putting money towards your emergency fund.
Once the emergency fund is fully established, then you can focus on these other financial goals.
- Contribute minimum to get the maximum 401(k) employer match
- Pay down all debt with a APRs of 8% and higher
- Fully fund your 401(k)
- Fully fund a traditional or Roth IRA
- Save for other financial goals (i.e., car, home downpayment, wedding, etc.)
Savings accounts are the best choices for emergency funds because they’re safe places for your money, they’re easy to access and they pay interest. (Don’t focus too much on interest rates though -- your primary goal here is to accumulate savings.)
When an emergency hits
By not planning for life’s random emergencies with a rainy day fund, we are setting ourselves up for financial turmoil.
If you’re one of the 64 percent of Americans who lack $1,000 to cover something like an emergency room visit, the following table will be an eye-opener for you.
These are some common options you could use to pay for a $1,000 medical bill:
Options to Pay for a $1,000 Medical Bill
| Cash Alternative | Typical Cost | Major Pro | Major Con | Sample Cost of $1,000 Borrowed + First Month's Interest |
|---|---|---|---|---|
| Credit card cash advance | 2-5% fee + 24.99% APR | Cash is available immediately at any ATM | Cash availability is subject to your credit card limit | $70.83 |
| 401(k) loan | 5% APR | Interest is paid back to the 401(k) | Pay 10% tax penalty + taxed at current tax rate if you don't repay on time | $204.17-$500.17 (if you don't repay on time) |
| 2-week payday loan | $15 fee per $100 borrowed | Easy to qualify for | High interest rates usually make it hard to eliminate the debt | $150 (effective APR of 390%) |
| Emergency Fund | $0 | No need to take a loan | Takes time to save money | $0 |
Without an emergency fund, these alternatives are able to get you the money you need to cover the expense.
However, look at the hefty cost that you’ll pay for not being prepared financially.
With cash advances and payday loans, you are faced with ridiculous interest rates that are likely to keep you swimming in debt.
With a 401(k) loan, you might get a low interest rate, but you’re going to pay hefty taxes and penalties if you have trouble repaying the loan (you usually have 60 days to repay the loan if you’re no longer employed).
