Last year, a survey conducted by Bankrate found that showed most Americans have less than $1,000 saved for emergencies.
What would you do if you lost your job and had less than $1,000 to your name?
Odds are, you’d start racking up debt or ask someone to borrow money until you can get back on your feet.
That’s why having an iron-clad emergency fund is so important.
In this article, I’ll give you our seven steps to building the ultimate emergency fund. Let’s first start with establishing long-term goals.
Step 1: Set your long-term goal
This is the very first step to building an emergency fund. Without a long-term goal, you will have no idea where to set your sights. Set a meaningful and achievable savings goal for at least three to six months of living expenses. This might seem like a lot now, but once you get the ball rolling, you won’t want to stop.
And don’t forget that an emergency savings account is just the start. Having emergency savings to fall back on or saving for a down payment on a home is critical for your financial well-being. But when you think long-term, don’t forget about retirement. You won’t have a financial future if you don’t eventually save for retirement.
While we’re just focused on an emergency savings account right now, I want you to be thinking long-term. Plus, when you think about compounding interest, it makes a long-term vision even more appealing. We frequently update the best savings accounts you can find on our site, and below is a table updated daily with the best rates and where to find them.
So why is it important to set goals?
Having long-term financial goals will provide you clarity. Having a distinct image in your mind of what you want will help you get to where you want to go.
You can be motivated to do a lot of things, but unless you’ve transferred these into clearly outlined goals, you are less likely to meet them. It’s like being motivated on January 1st to lose weight and go to the gym. How many of us actually follow through with those goals by even mid-year?
So write your goals down, share them with friends and family to keep yourself more accountable, and check in on them frequently. You can even use an app like Strides to keep track of your commitments and goals.
Step 2: Pay off high-interest debt
Credit Card balances collecting 20 or 30% interest need to be paid off first. When following our seven steps to building an emergency fund, we recommend using the Avalanche Method for paying off your debt.
With the Avalanche Method, you’ll first list out all of your debts from highest interest rate to lowest interest rate. Make a note of the minimum monthly payment. If you’re not sure what the monthly payment or total balance on debt is, you can check your credit report, log into the account online, or call the lender directly.
Once you have all of your debts listed in this order, you should set up an automatic payment to all of them for the minimum. This will ensure no debt goes unpaid and you’re at least making some headway on your balances.
After that, you should throw everything you can at the highest-interest-rate debt first. Work as hard as you can to put every dollar possible toward this balance until it’s ultimately paid off. Once you’ve knocked the debt out completely, you will roll that minimum payment onto the next highest interest rate, and so on and so forth.
The goal is to compound the monthly payments of each debt you pay off onto the next debt you’ll be tackling so 1) you don’t think you have that extra money lying around now that the debt is paid off and 2) so you can accelerate each debt being paid off that much faster.
You can easily track your debt paydown by using our Debt Snowball and Debt Avalanche calculator.
Step 3: Build one month’s worth of savings
When you’re high-interest debt is under control, focus on saving one month of living expenses first. This might take a while, so the first step here is to create a meaningful and realistic budget. Don’t assume that everything you spend money on during the month is considered a necessary living expense.
Since this is an emergency fund, you need to refocus your mind to view it through the lens of “What if I lost my job?” or “What if I experienced a major financial emergency?” If right now you shop at Whole Foods and buy nothing but organic food, I would imagine that may change slightly if you were to lose your income.
So what I’m saying is review your monthly expenses. See where you can cut back and see what might not be an actual necessity. Take that number and shoot for it as a target for your savings account. Remember, this should be enough to get you through one month of living without any income.
Step 4: Divide extra cash between debt and savings
Once you have a month saved up, divide your extra money between paying your debt and your emergency fund. Once you’ve reached this point, you should have one month’s worth of savings in an easily accessible account in case of emergencies (such as a money market or savings account).
If you followed my advice above, you’ve also created a realistic budget for yourself, which should include debt payoff and savings. Having, and sticking to, a budget should create some additional money for you at the end of the month.
Earlier in your steps to building an emergency fund, I recommended you put all of this money toward the debt that was in the 20 and 30% range. Now that that’s been wiped away (hopefully), you can use that extra money to split between remaining debt and your savings account.
I love this idea of balance, too. There are so many experts out there that give you advice that is too extreme. Some people love Dave Ramsey, for example. I do think he’s helped a lot of people achieve financial freedom, but his advice has flaws.
He tells us to save $1,000 for emergencies then put everything else we can toward our debt. My thought has always been, “what if the emergency is more than $1,000?” If that happens, we’ll go right back into debt to cover ourselves.
So instead of being extreme and saving every penny or putting everything toward debt, find a balance. Start with a 50/50 split and see if that works for you. If you want to make it a little more lopsided, such as 60% debt and 40% savings, do that. But don’t go too far off from splitting this extra money.
It’ll take longer to save and longer to pay your debts down, but overall, striking a balance when it comes to your finances is never a bad idea.
Step 5: Take advantage of your employer’s 401(k) match
If your employer offers a 401k match, make sure you’re taking advantage of this. If you aren’t contributing enough to get the full match your employer provides, you’re actually leaving money on the table. For some of us, even a 5% contribution can hurt if we’re living paycheck-to-paycheck. But you have to consider the dollars you’re losing by not taking advantage of a match.
Say, for example, your employer matches dollar-for-dollar up to 5%. That basically means that you contribute 5% and your employer will add (match) another 5%–giving you a total of 10% of your pay in a 401(k).
That’s like doubling your money for free. Nowhere else can you get this kind of return.
There are catches, of course. For one, you’ll have a vesting period–meaning you’ll have to be with the company for a certain amount of years before that money officially becomes yours. I just did a rollover for a retirement account from a company I left after only under two years. I missed out on about $3,000 because I wasn’t fully vested, which took place at two years.
So as you’re contributing (and going along with our whole long-term goals vision), you’ll want to anticipate staying with the company long enough to become fully vested, so you aren’t leaving any extra money on the table.
Step 6: Pay off low-interest debt
By this point, you’ve been chipping away at your debt and putting a little extra into your savings account. When you reach your emergency savings goal of three or six months of expenses, use your extra cash to pay off more debt. You can, and should, continue to put money into your emergency savings account, but the primary focus here is to knock out the remainder of those pesky debt balances.
I wouldn’t suggest going after significant balances like your mortgage right away. But things like car loans, home equity lines, and student loans are all fair game. I do agree with Dave Ramsey on this one–save the mortgage for last.
At this point, you can continue with the Debt Avalanche method, or switch to the more common Debt Snowball method. The only significant difference is with the Debt Snowball method, you’re paying off the lowest balance first–not the highest interest rate debt first. It’s more psychological than mathematical, but for many people, it works.
You can read more about the differences between the two approaches here.
Step 7: Don’t dip in unless you have to
Remember, this money is in case of emergencies only. Do not break into it unless absolutely necessary. This may be an unpopular opinion, but even if you find yourself internally screaming for a vacation an hour into your workday, this is not an emergency.
It’s like walking a tightrope with a safety net. There’s nothing to fear when you have a cushion to fall back on. You just get back up and keep on going.
That’s why I would advise at all costs, do not touch this money unless it’s essential. And like the vacation example above and in the video, you should also evaluate what indeed constitutes an emergency.
Things like a job loss, a medical emergency, or a severe issue with your home that isn’t covered by insurance come to mind when I think about financial crises.
Do your best not to tap into your emergency savings, even when you do experience an emergency. By this point, your debt should be reduced, and you may be able to take care of the crisis without touching your safety net.
Finally, I would recommend keeping the money in an account that’s liquid, but not too liquid. A savings account, for example, might be too liquid for some people since they can quickly transfer money from that account into their checking account with the click of a button. It pops into your checking almost instantly.
Instead, look into something like Betterment, where you can choose a Safety Net goal and keep the account at a relatively low-risk, focusing primarily on bonds and cash equivalents. This not only helps your money grow faster, but it’s a little more tedious and time-consuming to get the money out. This will help you think twice about dipping into your emergency fund.
A high yield savings account will limit your withdrawals and also encourage you to save. The more money that sits in your account, the more money you’ll earn with larger interest rate than a typical savings account. How do you know if you’re getting a great rate? Here’s our deal of the day:
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Read more: How to Build an Emergency Fund?
Building a true emergency savings account isn’t easy. It may sound easy, but it’s not. You’ll have to make sacrifices and be very in-touch with your money.
You can’t exactly set-it-and-forget-it and just hope your checking account doesn’t overdraw each month. You need to make a strict budget and observe your money. You also need to have self-control and cut back on spending.
Paying off debt can be frustrating and defeating at times, but if you create goals and track them (visually even), it will be so much more satisfying when you achieve those goals.Topics: financial planning • Money and Life • Personal Finance • Videos