How can you protect yourself from future cash crunches? Simple, by building some emergency savings.
Savings can come in a variety of formats, including retirement accounts, savings accounts, and brokerage funds. We are going to focus on the most basic forms of savings, the emergency fund. Specifically, we’ll talk about what an emergency fund is, what form it should take, and how much you need.
An emergency fund is money that you’ve saved up for unexpected expenses and is not set aside for anything other than emergencies. That means your kid’s college savings or the Christmas fund doesn’t count.
Emergencies can take a variety of forms, with common reasons including job loss, accidents and medical bills.
In general, you don’t want to dip into emergency funds for normal expenses except if you’ve experienced the loss of a job or an income reduction. You’ll never want to use the money to fund a vacation or other luxuries: this is something you should save for separately.
An emergency fund is intended to meet unexpected expenses without needing to rely on credit cards or other forms of debt. Instead, you can just write a check to cover the emergency and replenish the fund as soon as possible. Think of it as taking a loan from yourself and then paying yourself back interest-free!
What Does an Emergency Fund Look Like?
Emergency fund money should be in a different form than other savings types. We generally save for retirement by contributing to a 401(k), an IRA, or other investment account. Then, the money is invested in the stock and bond markets, etc. Income and appreciation on the assets are expected to grow over time to fund retirement (or another long-term goal).
Emergency fund money should be kept in low risk, liquid accounts. We recommend that cash be placed in a separate checking, savings, or money market account so it doesn’t mix with your everyday accounts.
A wonderful choice is an online savings account. They usually come with higher interest rates, and the extra time it takes to transfer to your primary account can help limit impulse buying with your emergency fund.
How Much Do You Need?
Experts have different opinions and we’ll take a look at the various options. The amount needed depends on your level of expenses, number of dependents, different sources of income, and overall career security.
. Some industries are highly vulnerable to recessions, while others are not. For instance, look at the COVID pandemic. By far, the bulk of people who lost their jobs were in industries such as travel, tourism, hospitality, entertainment, and retail. The reason for this was simple: these industries involve gatherings of people, traveling from one place to another, or staying somewhere that isn’t home. During the shutdowns, people were generally not allowed to do these things, and the only retail or hospitality that could run were those deemed “essential.”
The above industries employment isn’t as stable, as any time there is a recession, these jobs go away first. Plus, since many are low-skilled, workers are a bit easier to replace. People in these industries are generally considered to have less stable employment, and with all other variables the same they need an emergency fund to cover the greatest amount of time without work.
For those in less stable employment situations, six months or more worth of expenses saved. This means the amount of money necessary to cover your basic expenses while you look for additional work.
Basic expenses should include housing, transportation, minimum payments on any debt you can’t put into deferment (think student loans), food and medicine, essential household items, and utilities including internet.
Don’t include the amount you spend on luxuries or non-essential expenses. This includes eating out, going to the movies, or going on vacation.
White collar and union jobs tend to fair a bit better during recessions, and are often viewed as stable career paths. This category includes lawyers, financial advisors, engineers, accountants, teachers, administrators, etc.
While there are sometimes significant job losses in these areas, they are rarely as severe as what people in the retail/hospitality service industries experience. Not only that, but high skilled workers tend to have an easier time finding new jobs.
In those with stable employment, experts agree that three months of expenses set aside are adequate. To be extra safe, you can always try for three months of salary rather than expenses.
Unemployment should help your emergency fund last longer, if you can get and keep it. Your considerations for what is essential should be the same as for a less stable job situation. Stick with the essentials plus unavoidable contingencies.
More Than One Income Source
Having more than one income in the household can help mitigate unexpected life events. If you have a partner, its more common for only one of you to be out of a job at any given time. You will only need to replace the income lost, not all of the household income.
In these cases, your emergency fund can be smaller. Having enough income from one of the sources can help with paying expenses. Furthermore, certain expenses like childcare and transportation can be reduced. If you have children and one of you is out of work, the out of work parent can provide childcare.
Having Too Much Cash
Having a nice emergency fund saved up feels good, because there’s cash available quickly when needed. No more tossing and turning at night every time some unexpected expense pops up, because you don’t know how to cover it.
However, having too much cash in your emergency fund can actually cost you money. Inflation will eat away at it over time. To avoid losing purchasing power, invest non-emergency savings in other places where it can grow in value.