On the excitement meter, a “rainy day” fund might barely move the needle, particularly when compared with other financial goals such as saving for college, a retirement account, or a down payment on a new home. Yet investors who fail to include an emergency fund in their planning do so at their peril.
“Being unprepared for an emergency—anything from a flood to losing your job—can force you into a financial hole,” says Beth McHugh, vice president of market insights at Fidelity. “The unexpected can happen to anyone, regardless of age or income level, and it can take years to recover if you are not financially prepared.”
A recent study published by the National Bureau of Economic Research and the Brookings Institution found that 50% of Americans—and nearly 15% of households earning $150,000 or more a year—couldn’t come up with $2,000 in cash to cover an unexpected auto emergency, medical bill, or home repair.1
This is why creating an emergency fund should be considered a priority. Maybe you’re just starting a career and are inclined to take your chances. Or maybe you think your net worth has grown enough to make an emergency fund unnecessary. The problem is, you may be wrong. Having a cash reserve can help protect you against unexpected financial difficulties that can have lasting consequences, even if you feel you are in good shape today.
How much do you need?
Fidelity believes a good rule of thumb to follow is to have three to six months of living expenses tucked away in an emergency fund. One size, however, does not fit all. You will need to take into account your expenses, liabilities, and other individual circumstances in order to get a dollar figure that suits your needs.
If you’re single and on your own but have family backup, you might be comfortable with three months of savings. However, if you have a spouse, kids, and a mortgage to support, you might sleep better with six months or even 12 months of funding in reserve.
Remember to consider the full list of potential emergencies you could encounter, which might range from a disability or illness to a major housing repair or loss of employment. Make sure you check your disability insurance—either at work or as an individual—so that you know both how long your policy requires you to be disabled before benefits begin and how long they’ll last.
And when you are calculating your living expenses, keep in mind that if you lose your job, you’ll also lose your health insurance coverage. This means you’ll need additional emergency fund money to cover the cost of your health care coverage through COBRA.
Coming up with the cash
Once you’ve decided how much in emergency savings you’ll need, you’ll have to find the dollars to fund your cash reserve. A windfall such as an inheritance or a gift from a parent or grandparent is a great source of cash for starting a rainy day fund. Most people, however, will likely find that the process of building an emergency fund takes place while juggling other savings priorities, such as retirement, college, or a home purchase.
“Make a monthly budget and include an emergency fund contribution as part of it, along with contributions to your retirement plan, even if the contributions aren’t as large as you’d like them to be initially,” says McHugh. “When you reach the target number for your emergency fund, you can start working toward maxing out your contributions to a 401(k) or 403(b) plan, IRA, or other tax-advantaged plan.”
This initial budget can also include small contributions toward other goals such as college funding or a home purchase, just to get in the habit of doing so, she says. Then you can increase the contributions as your income grows and you feel you have enough to fund both your emergency fund and your retirement accounts.
Decide if you need one account or several
These days, it’s tough to think about tucking tens of thousands of dollars into a traditional savings account earning a paltry 0.5% or less. So it may make sense to be creative, and consider putting your money into a couple of different kinds of accounts that can serve multiple purposes. Taking a mix-and-match approach may also be a way to potentially increase the return you get on your money.
Money market funds, for example, may offer somewhat higher earnings than a savings account. You can shop around at Internet-based banks, which often offer better rates than brick-and-mortar banks. It’s important, however, not to confuse a money market mutual fund with an FDIC-insured money market deposit account, which earns interest in an amount determined by, and paid by, the financial institution where your funds are deposited.
Another possibility is purchasing certificates of deposit (CDs), whose rates may be higher still. Of course, there can be stiff penalties for taking money out of a CD before it matures, so that means you need to think about timing. One possible scenario would be to “ladder” a series of CDs with different maturity dates. For example, if you bought a 12-month CD on the first day of each month for a full year, you would always be within a few weeks of having a CD ready to mature should an emergency arise.
Some people view their 401(k) plan as a source of emergency cash, because you can borrow money from a 401(k) if your plan allows. This approach, however, comes with some real perils, says McHugh. If you leave your employer for any reason, you will likely have to pay the loan back immediately. Moreover, if you fail to pay the loan back, you’ll be subject to both income tax and a 10% penalty.
Keep your rainy day fund up to date
Once you have established your rainy day fund, try to resist the temptation to dip into it for nonemergencies. If you start to treat it as a backup when you’re running short, it’ll disappear before you know it. As your expenses grow, so should your cash reserve.
Likewise, if your expenses decrease—as children leave the nest, for example—you might be able to trim your emergency fund. To keep it current with your changing circumstances, consider making it part of your list of items to revisit during your annual financial checkup.
Whatever your age or income level, an emergency fund is an important part of a well-rounded plan for your financial security. Life is full of competing demands for your money, and a cash reserve can play a crucial role in keeping you on track with your other financial objectives.
Before investing, consider the funds’ investment objectives, risks, charges, and expenses. Contact Fidelity for a prospectus or, if available, a summary prospectus containing this information. Read it carefully.