How to Create, Build and Maintain an Emergency Fund
An Emergency Fund is one of the most foundational tactics to build a life-proof financial plan. The simplest way to think about an emergency fund is an amount of cash that is set aside from other checking and savings accounts and only used in case of emergencies (more on that below!). As much as we plan there are always things that surprise us and cost much more than we expect. Having an emergency fund will enable us to manage those emergency expenses without going into debt or having to sell investments.
1. How to Create an Emergency Fund
The act of creating an emergency fund is relatively simple. I strongly recommend opening a new account at your preferred bank (ask about high interest savings accounts) and use this account only for your emergency fund. That way there is never a question of whether that cash is for your emergency account (it is) and how much is in there. Most banks allow you to open new accounts online, but you could also go to your banks branch office to inquire about opening a separate bank account for your emergency fund. This should only take 30 minutes or so and should be relatively straightforward.
2. How Much Monday to Keep in Your Emergency Fund
This is a hotly debated topic in the personal finance community with some people advocating for 3 months of living expenses and others up to 1 full year. My opinion here is that the real answer falls somewhere in the middle and is dependent on your own circumstances and risk tolerance. I found a graphic created by Brian Feroldi (@BrianFeroldi – follow him on X for a ton of great content) that I think does a nice job at laying out a way to calculate it for yourself. In the chart below, you walk left to right and add months based on specific life circumstances to get to your total amount. For me personally, I start with 1 month, add 3 months for having dependents (kids), add 1 month for growing/ few jobs in my professional field and add 1 month for my sources of income (I don’t include my retirement investments in this). That results in me needing to put 6 months of living expenses into an emergency fund.
While this is by no means a one size fits all approach, doing a similar assessment for your life is probably needed to understand how many months of living expenses should you put into your emergency fund and the answer is probably somewhere between 3 and 12 months.
The next popular question is how do you determine your living expenses? That also is debated, but I recommend reviewing how much money you spend in a year on shelter (rent, utilities, insurance, etc.), transportation (car, bus tickets, gas, insurance), food and any other critical expenses that you wouldn’t easily be able to give up if you didn’t have a job (e.g. cell phone). I then divide that number by 12 to get an estimated monthly expense. The reason I recommend an annual number and divide it is because most of our expenses are pretty lumpy month over month and some expenses only hit one time per year (like taxes, some insurance payments etc.) so taking an annual amount ensures we capture those expenses. If you don’t know your annual living expenses you can either (1) document a few months of expenses and then use that as your approximate or (2) use your credit card and bank statements and go back and calculate what you spent over the last year on all your expenses – this assumes you use credit cards for most of your expenses. Don’t let this step get in the way of building your emergency fund – you don’t need to be exact here.
3. When to Use Your Emergency Fund and How to Pay Yourself Back
They key word here is emergency. This cash should not be used to go to a restaurant, vacation or for that new watch you want. This is specifically for large and unexpected expenses like auto / home repairs, health expenses and unexpected loss of your income. It’s going to take some self-discipline to truly set this money aside for only emergencies, but it’s important that you don’t allow yourself to dip into it for anything else. Just one-time could be a slippery slope to a really bad habit.
When (not if) the time comes when you need to use your emergency fund for an actual emergency, you’ll need to remember that you need to pay yourself back so that you always maintain your desired number months of living expenses. I personally have a rule that I won’t shift my other “investing” money so I’ll cut my “fun” expenses like going out to eat and shopping until I pay myself back. It usually takes a couple months, but I create a plan and stick to it. I also gamify it that I create a reward for myself when I do pay it back.
You should also review your emergency fund once a year to make sure you still have the right amount of money in it. Life circumstances are always changing, but it’s important to maintain the appropriate amount of money in your fund.
