A crucial step for financial security is having an emergency fund of about half a year’s salary. No job is secure and life has been known to throw curve balls. An emergency fund can provide a buffer for unemployment or unanticipated expenses.
What Is an Emergency Fund?
An emergency fund is money that is set aside to cover unexpected emergency expenses, such as job loss, medical and dental expenses, replacing your home’s HVAC system, or expensive car repairs.
The money in an emergency fund should be easily accessible in an emergency.
Start Small When Building an Emergency Fund
An emergency fund is a major chunk of change and can be intimidating. The first step on your way to building an emergency fund after you graduate is to start small with a more attainable goal.
Start by saving around $1,000. You should be able to save this amount of money in less than a year. If you are paid biweekly, save $40 from every paycheck. That’s a little more than a dollar a day.
That won’t be enough to cover big expenses, like job loss, but it can cover the cost of an emergency room visit. More importantly, it gets you started toward a bigger emergency fund.
If saving $1,000 is too much, then aim to save the equivalent of one biweekly paycheck.
Where to Save the Emergency Fund
Some people keep the emergency fund in their checking account. While that certainly is accessible and can help with your cash flow, there’s a risk that you’ll be tempted to spend the money.
It is better to keep the emergency fund in a separate account, such as a saving account that is linked to your checking account. The money can be easily transferred to your checking account when needed, even on short notice. Requiring an extra step before you can access the money can help prevent impulse spending.
If you save the emergency fund in a high-interest savings account, you can earn some interest on the money.
Alternately, you could keep your emergency fund in a bank certificate of deposit (CD). There is a interest penalty for early withdrawal, however this interest can be deducted on your federal tax return. If it is a true emergency, you won’t mind the interest penalty.
As your emergency fund grows, you can save the money in several CDs, with staggered maturity dates. That way, there will always be some money available within a month or two.
How Much to Save in an Emergency Fund
A fully-funded emergency fund is about half a year’s salary. That’s enough to cover your day-to-day expenses during unemployment. The average time in unemployment is around the 6 month mark, but this can vary depending on your career options and flexibility.
If you want to be more precise, you can calculate your current monthly expenses. Track your spending for a month, counting only the essential monthly expenses. This includes insurance, housing, groceries, and debt payments.
More frivolous expenditures like eating out, Amazon Prime purchases and your hobbies can be excluded from this amount. These are things you will put-on hold while out of work.
Don’t overlook any expenses that are billed annually. Divide those expenses by 12 to obtain a monthly figure.
Once you have calculated your essential monthly expenses, multiply this number by 6, corresponding to 6 months of expenses. That’s the amount of your fully funded emergency fund.
Fully Funded Emergency Fund = 6 x Monthly Expenses
Building an emergency fund is not an exact science. You might overlook some expenses or you might be unemployed for longer, so throw in a fudge factor. Or just save half a year’s salary, since that should be enough except in the most extreme circumstances.
Emergency Fund vs. Debt Payoff
How do you prioritize your emergency fund if you also have debt, especially student loan debt?
An emergency fund is more important than accelerating your debt payoff.
If you prioritize paying off your debt first, you will leave yourself exposed to emergencies for many years. You might not encounter an emergency for several years, but eventually you will, and it will be challenging to deal with it. Without an emergency fund, you will need to lean on credit cards and loans when illness or a job loss hits.
Focus on setting up the emergency fund as a safety net first, before you leap into accelerating loan repayment. There will be plenty of time to pay down debt after you have built your emergency fund. Building an emergency fund should take only a few years. Once the emergency fund is built, you can redirect the savings toward paying down your debt.
Easy Ways to Build Your Emergency Fund
Start Now - The best time to start is the moment you graduate and secure a position. Waiting could lead to lifestyle inflation and spending habits that are hard to break.
Automate Your Savings - As a new professional it can be easy to get sucked into making the purchases you have always dreamed of and ignoring a savings fund. In order to avoid temptation, automate your savings so you don’t have to think about it.
Cut Expenses - Start cutting expenses by cancelling all subscriptions and other automated expenses. Then, track the amount spent on entertainment and personal hobby purchases. Create a limited amount allowed as “fun money” each month to cut down in this area.
Cook at Home - Making meals at home can cut grocery bills and make more funds available for saving. Skip the daily latte and bring your own lunch to work to cut your food budget even more.
Save Your Income Tax Refunds - When you file your taxes and receive a refund, move this chunk of money straight to the emergency fund.
Increase Contributions with Income - If you get a raise, increase the contribution made to your emergency fund. Save any bonuses in your emergency fund.
Pick Up a Side Hustle - Working more sounds stressful. However, side hustles can be something you enjoy like coaching soccer or walking your friend’s dog. Set a time limit to the hustle to avoid burnout and allow for re-evaluation.
Spending Freeze - Freezing your spending can be a good way to reset your spending habits and save a little more in the emergency fund. It will also force you to find alternative activities that do not cost money such as hiking or hosting the next get-together at your home.