In 2020, as the global pandemic hit the world hard, millions of Americans found themselves out of work, seemingly overnight. And not having a job probably meant no health insurance, so if you were hospitalized with COVID-19, you were simultaneously battling the virus and medical debt. A medical emergency, such as a COVID-related hospital stay without an emergency fund, can bankrupt you.
But it doesn’t take a global pandemic to justify the need for an emergency fund. Maybe your house is flooded. Maybe your dog ate a bag of candy. Maybe you need to fly across the country to visit a sick family member.
All this can seriously hit your budget, so you need an emergency fund.
Here’s what you need to know to get started building it.
What is a reserve fund?
A reserve fund is money that you have set aside for unforeseen financial circumstances. Things like:
- You got a flat tire and had to pay for towing and a tire
- You lost your job and have to pay bills
- You need emergency gallbladder surgery
- You have a fire and need to replace the electrical wiring in your home.
- A family member has passed away and you need to pay for the funeral at the last minute.
Unforeseen financial emergencies do not include:
- Down payment for a new home
- Down payment on a new car
- College education
- Great deal on a cruise holiday
- Replacing a worn carpet with a hardwood floor
- Normal wear on your tires (this should be budgeted for, not an emergency)
- New Super Bowl TV
While these things may seem important to you, the unexpected financial situation is something you didn’t know you had, so you didn’t have a chance to plan for it – meaning you probably didn’t have the money to cover it.
An emergency fund takes the guesswork out of where the money will come from. This gives you peace of mind so if an emergency arises, you can focus on getting through the crisis rather than how you will pay for it.
How much should you have in your reserve fund?
The financial rule of thumb is that you should have at least six months’ worth of expenses in your emergency fund.
Of course, everyone’s expenses are different, so the dollar amount needed to get through an emergency varies from person to person. Some people believe their emergency fund can cover luxuries, while others stick to a more modest fund that provides just enough to pay the bills.
Source: Giphy.com
To help you calculate how much you If you need to save money, use our handy reserve fund calculator.
Six months of savings can seem like a lot, especially if you’re currently living paycheck to paycheck. But before you panic and give up on anything, keep in mind that your emergency fund is something you build up over time. You’re not going to save six months of expenses overnight.
Start small. Set an achievable amount as a goal that won’t stress you out based on what you can afford to save. Make small changes, such as eating less out of the house or buying used items instead of new ones, and hide the extra money.
Once you get comfortable with savings, you can set higher and higher target amounts until you have enough money to cover six months of expenses.
Read more: How to budget
Why do you need a reserve fund
Maybe you have a great job with a decent income and you think that’s enough for you. But if anything the last few years have taught us, it’s to expect the unexpected. And with skyrocketing inflation and a looming recession, you need an emergency fund now more than ever.
Here are some examples of why you might need an emergency fund:
- In case of loss of income If you get fired tomorrow, do you have enough savings to cover your living expenses until you find another job? What if your company is downsizing and you are fired without severance pay? These are real situations that can happen to anyone.
- In the event of a medical emergency – COVID-19 is a perfect example of an unexpected medical emergency: a global pandemic that has left millions of people in hospitals, unemployed and unprepared. Even if you have health insurance, it does not cover all costs.
- In case you have a family emergency – What will you do if your dog gets sick and needs to go to the vet? What to do if your child has a chipped tooth during recess? Credit cards are not the best option right now given the high interest rates. Even seemingly minor emergencies can ruin your finances if you don’t set aside money for them.
- If you need urgent home repairs – What to do if you are affected by a hurricane or flood? Even with insurance, you will have to pay out of your own pocket for home repairs, temporary accommodation, and property replacements. Without this emergency savings fund, these expenses could bankrupt you.
Read more: Have you been hit by a hurricane this year? You Can Claim a Disaster Tax Credit
Where to hide your reserve fund
If you’ve been saving money in a shoe box under your bed, pay special attention to this section.
Financial educators often suggest opening an account separate from the bank you regularly use. This will save you from the temptation to withdraw money for unexpected expenses.
You also want to make sure it’s an account that you can easily access in case of an emergency and where your money is not blocked (for example, a certificate of deposit not suitable for a reserve fund).
So, what type of account should you open?
High Yield Savings Account
A high yield savings account is similar to your standard savings account. The difference is that it generates a much higher return on your money than the national average income from savings accounts.
A traditional savings account is not designed to make money, which explains why the average interest rate on savings accounts is only 0.17%, according to the Federal Deposit Insurance Corporation (FDIC). On the other hand, a high-yield savings account multiplies this number by a factor of a dozen, reaching rates up to 2.70%.
However, access to these accounts is not the easiest, as they usually require money to be transferred to a checking account, which can lead to a delay in receiving them. However, this can be a good thing, because the wait may just be the deterrent you need to leave the money alone.
Read more: Comparison of the best high yield savings accounts
money market account
Money market accounts are very similar to high yield savings accounts because they also earn higher APY than traditional savings accounts. These accounts are easily accessible: some come with a debit card and you can even get checks!
Just be aware that money market accounts allow a limited number of withdrawals each month (such as a savings account) and generally have higher minimum balance requirements than traditional savings accounts.
Read more: Comparison of the best money market accounts
Traditional bank account
This is the most common account used for emergency funds, primarily due to the availability of these accounts.
With traditional checking and savings accounts, you won’t get as much interest as money market or high-yield savings accounts, but you’ll earn some, and their convenience is perfect if you’re dealing with a fast-moving emergency.
Read more: Comparison of the best banks of the year
How to create a reserve fund
You need to budget a bit to make sure you put the right amount in your emergency fund – not too little, but not so much that you sacrifice other things like paying off debt or just enjoying life. .
Here’s how to break it down:
- Define your target savings goal. Use our reserve fund calculator to determine how much money you need to set aside to cover your monthly expenses for six months.
- Calculate how much you can afford to save each month. This will require you to create a monthly budget to keep track of your current income and expenses. Find out where you can cut back or where you have surpluses that you can put into an emergency fund.
- Pay yourself. Just like you pay your monthly bills, make sure you pay yourself! When payday arrives, transfer the set amount to your reserve fund account.
- Take advantage of contingencies. If you can’t cut your spending any longer and don’t have a surplus to save, you can use the “surprise” or “found” money to build your reserve fund. Typical sources of money found are tax refunds, bonuses from work, and money you receive as gifts.
- Review and review. Each person has variable monthly expenses. Review your budget regularly and make adjustments as needed. Your emergency fund will be moot if you’ve put so much into it in one month that you can’t afford groceries for 30 days, or you’re forced to miss credit card payments and pay penalty interest.
Wrong Kinds of Emergency Funds
There are two things that people often use instead of an emergency fund. Do not do that. While they will give you the money you need in the short term, you will pay more in the long term.
Do not use your retirement accounts and investments
Retirement accounts are the main investment asset of most people, and for many it is their net worth. Only source of significant savings. Therefore, you may be tempted to use these remedies in an emergency, but this has serious consequences.
Source: Tenor.com
Using your retirement savings may temporarily solve your need for cash, but it will create additional tax liabilities next year. At a minimum, you will need to pay regular income tax on the withdrawn amount. But if you’re under 59½, you can also incur a 10% early withdrawal penalty.
Those with investment accounts may feel the same pressure to sell stocks or funds to raise cash in an emergency. But then again, you will face financial consequences. Either you sell the investment at a loss, while recording a loss, or you sell the investment at a profit, creating a capital gains tax liability.
Don’t push lines of credit
Many investment advisors advise their clients to “invest fully”. The reason is that since stock returns are much higher than fixed income investments, keeping money in savings is a guaranteed loss of money.
From a purely financial point of view, this advice is accurate. However, many people in such a situation rely on lines of credit as an emergency fund.
The problem with this strategy is that it simply shifts the need for money from the present to the future. Of course, your immediate need for cash will be met by the lines of credit, but you will have to pay them back later.
Either you will pay out the money in large lump sums, or you will add a new and semi-permanent monthly payment to your budget.
bottom line
Having a reserve fund gives you financial peace of mind. Knowing that in the event of an emergency, you have the money to cover it eliminates the economic instability associated with not being prepared. Even if you need to start saving in small portions, it’s important to just start.
Featured Image: Sinn P. Photography/Shutterstock.com