Co-founder and CEO
We thought you might.
Join the hundreds of thousands of people who are taking control of their personal finances and investments with tips and market insights delivered straight to their inboxes.
Personal finance best practices say that before you even think about investing, there are two things you need to do first. First: pay off any high-interest debt (i.e. credit card debt-- this doesn’t include mortgages and bank loans). Second: save for a rainy day.
Let’s focus on the second part, building and managing an emergency fund.
But, before we get into calculating how much you need for your emergency fund, how to save for it, and where to keep it, there’s one thing you need to remember: This money is meant to be used; it’s not off-limits. You’re giving yourself a gift to be able to face what life throws at you. So don’t feel bad about using it when you inevitably have to use it, or a portion of it.
Your emergency fund should cover at least 6 months’ worth of expenses. To determine this amount, add up how much you spend in a single month on things that you can’t go without (e.g. food), and the contributions you owe each month (e.g. monthly savings or a mortgage).
Even if you were to lose your entire monthly income, your savings goals shouldn’t be compromised-- they’re there to make sure you reach your long-term life goals! Don’t let an emergency get in the way of that. But maybe hold off on that extra coffee or designer bag.
Now you know the amount of your monthly expenses. Multiply that by 6 months. That’s your emergency fund target amount.
The next question you need to ask yourself is: “Do I have this much in a cash or savings account?” If the answer is “yes”, can you afford not to touch it unless you have a real emergency? Yes? Skip to the next section. No? You need to make a savings plan to get there.
To save up the difference, a structured monthly plan is the easiest way to keep yourself accountable and on track.
Look at your monthly expenditures to know how much you can you afford to put aside each month. From there, calculate how long it will take you to build your emergency fund with your monthly savings amount:
So, let’s say you need $36,000 USD for an emergency fund, and you already have $10,000 USD in cash, that means you need to top-up $26,000 USD. Then, if you can save $750 USD per month, it will take you $26,000 USD/$750 USD = 34 months to build your emergency fund.
That’s a long time!
To build the emergency fund in fewer months, you’ll need to save more each month, and that means you need to adjust your budget and reassess your monthly spending to top-up a little more each month. Can you skip that extra coffee (and definitely that designer handbag)?
If you are committed to building an emergency fund in a certain period of time, you can also calculate how much you need to save each month in that timeframe like this:
So, again, if you need $36,000 USD for an emergency fund, and you already have $10,000 USD in cash, that means you need to top-up $26,000 USD. If you need to save $26,000 USD, and you want to do it in 12 months, that means you would need to save $26,000 USD / 12 months = $2,167 USD each month.
If you can’t put aside larger amounts each month due to income and expense restrictions, consider whether you can make broader lifestyle changes. Could you be paying less for rent elsewhere so that you can put more money towards your future? Ask yourself if you’re willing to live less extravagantly so you can achieve your future objectives. These lifestyle adjustments will allow you to build your emergency fund more quickly and be prepared for whatever life throws your way.
And, that extra savings capacity will pay off beyond building your emergency fund: once you have your emergency fund, you can start putting that monthly savings amount towards other goals. This disciplined savings strategy could make the difference between retiring 5 years earlier, or buying a 3-bedroom home instead of a 2-bedroom home.
First and foremost, you need liquidity in an emergency fund. But that doesn’t mean you should put it under your pillowcase. For the first few months' worth of an emergency fund, look to keep it in a savings account that earns enough interest to keep up with inflation, or a low-risk liquid portfolio that earns interest.
If you can stick toonly using your emergency fund in these scenarios, then congratulate yourself for taking care of you and your loved ones responsibly! Then, temporarily put your other investing and savings plans on hold so you can put those funds towards your emergency fund again. If you have to buy that house 6 months later, then so be it: the well-being of you and your loved ones in the short-term comes first.
Insurance policies can be great, but they are a hedge, not an emergency fund. You should have an insurance policy that covers some of these high-ticket emergencies, but you should not view insurance as a cash equivalent. Life insurance claims can take time to process, and so you will often need liquidity before you are reimbursed. In short, even with insurance, you need significant liquidity.
Unlike other savings plans that have longer time horizons, emergency funds need to be built as soon as possible, because you never know when you’ll need unexpected cash. It’s important that you build your emergency fund before investing in any of your other financial objectives. Although saving for your down payment of your first home may sound much more exciting than building an emergency fund, it’s best to protect yourself and your loved ones with a safety net as soon as possible.