How to Build an Emergency Fund

How to Build an Emergency FundLast week I wrote about how my wife and I paid off a lot of debt in less than five years. An important part of getting out of debt for us was an emergency fund. A lot has been written about the importance of saving for a rainy day. But most of what you’ll read on the subject is either unrealistic or just not helpful.

For example, a common refrain is that you should save three to six months of income for emergencies. While this rule of thumb is fine as far as it goes, it can take some families years to reach this goal. And while they are trying to save, do they ignore paying off debt or saving for retirement? And by the way, is three months or six months best?

Dave Ramsey tried to address these issues. In his 7 baby steps, he advises folks to save $1,000 in an emergency fund and then tackle debt with gazelle-like intensity. As with the three to six month rule, Dave’s approach may be fine for some. But it raises at least two questions: (1) Why $1,000? I think most families need a lot more, and (2) Why does it have to be all or nothing? Why can’t you save for a rainy day, pay down debt, and save for retirement all at the same time?

And that brings me to the approach my wife and I followed. I’ll warn you in advance that we took steps that were far from conventional. But our approach underscores the fact that one-size-fits-all just doesn’t work when it comes to finances. So let’s walk through our approach—

How much to save for emergencies

How much to save for a rainy day is probably the most frequently asked question. Dave Ramsey says to save $1,000 and then start tackling debt. If your monthly budget were $10,000, savings of $1,000 would represent a 3-day emergency fund, which is not exactly the kind of thing that will help you sleep at night.

Rather than pretending that there is a single best answer to this question, here are the factors to consider when deciding what’s best for you:

  • The consequences of a financial catastrophe: If you are single living in an apartment with a supportive family, a job loss may mean moving back in with mom and dad. In contrast, if you have a family of four and little familial support, a financial crisis may mean looking for a homeless shelter. The greater the risk, the more you should save for emergencies.
  • The interest rates on your debt: If you are stuck with credit card debt at 30%, you’ll want to start paying it down as quickly as possible. As a result, a smaller emergency fund may be appropriate. If your only debt is at a much lower rate (e.g., a car loan or home equity line), the urgency to pay down your debt won’t be the same
  • Your access to cash: If you have a line of credit or retirement savings you can tap in an emergency, then a large rainy-day fund may not be critical. In our case, we went without any savings for a time because of our access to a line of credit and retirement savings. Liz Pulliam Weston recommended this approach in an interesting article about the $0 approach to emergency funds.
  • Your risk of job loss: While anything can happen, some of us are more at risk of losing our jobs than others. There’s no rule of thumb here; you have to assess your situation. But if you think a job loss is unlikely, a smaller emergency fund may be appropriate.
  • Your sources of income: If you have multiple sources of income (e.g., two-income family), it’s worth considering whether you can get by on smaller savings while you pay off debt. The point is that it’s probably unlikely, although not impossible, that you would both lose your job.
  • Your employer’s retirement plan: If you have an employer that matches 401k contributions, you’ll want to take advantage of the match as quickly as possible. This could mean building up your savings at a slower pace, all other things being equal.

With these factors in mind, here’s the approach we like best:

  1. Save One-Month of Expenses: As a first step, save one-month worth of living expenses before tackling any debt or investing.
  2. Begin paying extra on debt: Once you have a month of expenses saved up, split your extra money between paying down debt and building your emergency fund.
  3. Take advantage of an employer match: If your employer matches a portion of your 401k contributions, build up to investing enough to take advantage of the match. At one point, we were saving, investing, and paying off debt at the same time.
  4. Supercharge debt pay down: Once you’ve reached your emergency fund goal, direct your extra cash to paying off debt.
  5. Customize your solution: Be mindful of the factors listed above to tailor your approach to your specific circumstances. If you have debt at 30%, that will take priority over just about anything else, for example.

Where to stash your emergency fund

There are a couple of good options, and they depend once again on your specific circumstances. If you are just starting to build your emergency fund, I’d stick with a high interest savings account. Once you’ve build up a cushion, you can look to get some higher rates with CDs. I like the Ally Bank long-term certificates of deposit because they have relatively low penalties for early withdrawal.

As a related matter, you can also create a CD ladder to take advantage of high rates and have regular access to your funds. With current rates at historically low levels, however, sticking with a savings account is probably the best option.

Finally, as your investments grow and you eliminate debt, you may find little need to keep a lot of money in cash. Particularly with the low interest rates we see today, you may want to consider low risk bonds funds as an alternative to a savings account. Given the likelihood that rates will eventually rise, I’d stick with short duration funds so that a rise in rates won’t have a major effect on the price of the fund.

NEXT: Should You Stop Saving for Retirement to Pay Off Debt?

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Topics: debt

11 Responses to “How to Build an Emergency Fund”

  1. You can also set up a savings account where you put in a set amount each month from your paycheck automatically, even if it is $25 or $50 a month. Just make sure not to use it unless it is a real emergency.

  2. I think that your emergency fund needs to be higher than $1,000…but as you illustrated that credit card debt can carry rates as high as 30%, you need to make sure that kind of debt is paid off before even saving $1,000. Especially since credit is just about as liquid as cash these days.

  3. This is an issue that my husband and I have been working on since we got married 18 months ago. Just coming out of grad school, we didn’t have much in savings. You are right – we had trouble knowing if we should pay off student loan debt or if we should get an emergency fund going. We followed a similar plan to the one you laid out above and I’m happy to report that we have paid off thousands of dollars in debt AND have a three month emergency fund. Yay for us!

  4. I’m working on building an emergency fund, but it’s definitely difficult. I think starting with a 1 month buffer first is a great idea. I’m glad to know it takes several years and not just 1. I’m a little more optimistic, but I’m still inpatient.

  5. I used to sell investments, I would be very wary of the low duration bond funds. In theory, interest rate increases should not have as much of an impact, but I will tell you that reality and theory are far apart. We’re talking an emergency fund – I would never ever suggest an non-insured account for these monies. To paraphrase that well worn quote, I’m more concerned about the return of my principal than the return on my principal.

  6. I’d subscribed to Dave Ramsey’s $1000 suggestion for the longest time and, after having reached that goal, spent time paying down significant CC bills. Unfortunately, the need for a root canal and crown ($3000) obviously wasn’t covered with the $1000, requiring us to put it onto my CC. If I’d listened to my intuition, which said we’d need more than $1000 in savings, I would have been able to cover that dental work. As it was, having put the charge on my CC was a serious psychological setback to our financial position and came at a time when I’d voluntarily left a bad job situation and lost significant income. We’re still recovering from the “perfect storm” of events. I’ve learned the hard way- having more of a cushion, for us, trumps paying down debt.

  7. On reading this article how funny this subject was on my mind as I hope to be getting more hours. I know personally how important that a emergency fund is for I learned through trial and error many years ago. I’d been laid off and going through a divorce . I had to leave a turbulent relationship that left me raising two little girls. As much as I should have rolled over my 401k I needed it for survival. Like I said it was through trial and error I ‘d always kept a emergency fund. Even though it’s said we should adjust our w-2 so we don’t get a refund this is mainly how I got my emergency fund then I adjusted my getting a raise using the extra money to set up a emergency fund. This was many years ago for a injury set me back but it was a emergency fund that helped me through the times I couldn’t work

  8. Lawrence

    Oh for Christ’s sake: save more than you spend…you don’t need anybody to tell you how to do that. Keep that up your entire life and retirement will treat you nicely.

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