How to save for an emergency

Ask yourself 4 questions to help prepare for the unexpected.

Key takeaways

  • Save at least 3 to 6 months' worth of necessary expenses by funding your emergency savings account regularly, as you would pay a bill.
  • Consider saving in an account that pays some interest but preserves liquidity.
  • To really be prepared for anything, be sure to keep health and disability insurance coverage.

The forecast says rain? You pack an umbrella, just in case. Car has a flat tire? Good thing you keep that spare in your trunk. But what happens if your furnace or air conditioning breaks or you unexpectedly lose your job? Do you have a "just-in-case" fund set aside?

Maybe not. About 3 in 10 Americans would have trouble paying their bills in full if they had to pay for an unexpected expense of $400, according to the Federal Reserve.1 Here are 4 key questions to ask yourself to help make sure you can handle what life throws at you.

1. How much do you need?

Here's the short answer: Fidelity suggests setting aside at least 3 to 6 months' worth of living expenses. If you're single and on your own but have family backup, you might be comfortable with 3 months of savings. However, if you have a spouse, kids, and a mortgage to support, you might sleep better with 6 months or even more.

But there is a long answer. There are some things to consider that could help you customize the amount you may need to save for your situation.

Protecting yourself or your family from a potential job loss or loss of income is generally the number one reason to save for a rainy day.

But your situation may not warrant saving as much as 6 months' of essential expenses. If you could easily replace your job, saving 3 months' worth may be fine. If the opposite is true and it could be a long search to find a new job, saving up to 6 months' worth or beyond could make sense.

There may be resources available to help ease the impact of a job loss—unemployment benefits. Unemployment insurance benefits are available in all states and the District of Columbia, Puerto Rico, and the US Virgin Islands. But not all employees are eligible—your employer has to pay unemployment taxes. Nonprofit organizations, like churches and schools, are exempt from paying unemployment taxes.

Some states offer higher benefits than others. So it may make sense to factor your state's unemployment benefits into your calculations.

There are other factors that influence the level of unemployment benefits you could receive. For instance, if you have children or other dependents, your state may provide additional benefits.

Other considerations:

  • You must be physically able to work—so not disabled or collecting disability benefits.
  • You must be actively looking for a job.
  • You must have left your prior job involuntarily, without cause, and in good standing.
  • If you've received unemployment benefits within the 6 months prior to filing, your benefits may be reduced.

What about borrowing?

In some cases, borrowing to pay for an emergency might not be the worst thing. For instance, a home equity loan or line of credit could be an option.

2 caveats:

  • If you've lost income, borrowing to cover essential expenses is risky.
  • If you already have a lot of debt, relying on credit or loans in an emergency puts you further in the hole, which just makes it that much harder to get out.

2. How to come up with the cash?

There are a couple of ways to boost savings—even on a tight budget.

Think of your emergency savings fund as a bill. With rent or mortgage payments, contributing to a retirement fund, and myriad living expenses, you already have a lot to balance. But if you turn saving for an emergency fund into a monthly priority, you’ll get in the habit of contributing to it regularly.

Save an inheritance or gifts. Not everyone has a wealthy great uncle, but if yours happens to leave you some money, don’t fritter it all away. Consider using it to start your emergency fund and invest what is left over for other savings goals.

3. Where's a place to stash the savings?

It can make sense to separate your emergency fund from your spending money and other types of savings. That could mean a savings or money market account (different from money market funds). Those can be convenient and accessible options, but keep in mind that those accounts may earn less than 0.25%2 in interest.

Consider the following alternatives:

Money market funds tend to be a lower-risk place to store your cash, and generally offer better rates than your typical savings account. Unlike savings accounts, money market funds are not FDIC-insured.

Certificates of deposit (CDs) may offer even better rates than money market funds—but there is a catch. Many penalize you for taking money out before the CD matures. CDs may be a solution for a portion of your emergency fund but beware of tying up all your savings—a vital component of your rainy-day fund is liquidity.

When you need to dip into your emergency fund, consider withdrawing from more liquid accounts first. An example of a liquid account would be a savings account—your savings are easily accessed at no cost. Avoiding losses due to taxes, penalties, or market volatility is key.

Try to avoid withdrawing from retirement accounts like your 401(k) or IRA if you're not yet retirement age. You may have to pay taxes and a 10% penalty for the early withdrawal.

4. How to protect yourself with insurance?

Besides having cash that you can access in an emergency, insurance is another way to be prepared for one. Consider these 2 types: term and permanent. Just like it sounds, a term insurance policy covers a defined period of time while a permanent life insurance policy is with you until death, as long as you pay the premiums.

Look into disability insurance. Whether you have it through work or on your own, you'll want to know that you have enough in the event something happens.

Don't forget about health insurance. If you lose your job, your health coverage may go with it. Even if you are eligible for continuation of coverage through COBRA your premiums are likely to significantly increase. Factor in some additional money to cover the cost of health care, just in case.

The bottom line

There are many other circumstances besides losing a job that could require having cash on hand—like natural disasters, unexpected child care expenses, or a surprise medical bill that insurance won't cover.

You may not be able to plan for all of them but protecting yourself with insurance, having ample cash savings that are easily accessed, and keeping credit available, just in case, make a good start.

That’s one reason that Fidelity suggests establishing an emergency fund and then continuing to save 5% of your after-tax income for unexpected expenses.

Read Viewpoints on 50/15/5: a saving and spending rule of thumb

Everyone needs an emergency fund—no matter how old you are or what your income level is. And if you’re diligent about saving for it, you'll be ready for anything—rain or shine.

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