“Ahhhh!” I yelled in agony knowing it was too late. My fate had been sealed, or rather the fate of my tires. Thankfully, I had an emergency fund. But first, I had to make sure we were okay.
I was driving my brother to drop him off at the airport when I slammed into a pothole on the passenger side of the car. In retrospect it was more like a sinkhole, mercilessly engulfing anything that tried to pass over it. Anyone who’s ever driven on the highways around Philadelphia knows exactly what I am talking about.
Before impact, I frantically tried to veer out of the way, but I was boxed in by cars in the lanes on either side. I clenched my teeth and closed my eyes for a split second as I braced for the slam.
As if on cue, the car started to wobble and the unmistakable rattling of the wheels signaled that a tire had blown out. Thankfully, I was able to maintain control of the car and make my way to the right shoulder.
I was relieved we were all safe and healthy, but the damage to the car was worse than expected. Both passenger tires that hit the pothole had blown out. They each had holes the size of golf balls so they were 100% useless.
In what almost seemed like a scene out of a movie, five other cars pulled up behind us over the next 45 minutes, having hit the same pothole and gotten blowouts. Each person literally did the same exact thing after pulling over.
They punched the steering wheel, got out slowly to look at their tires, and then shouted “Noooo” at the top of their lungs as their arms flailed in agony. I almost thought I was on a hidden camera show because everyone’s reaction was so similar.
But looking back, it made sense. Especially since most people care more about looking rich than being wealthy.
The Average Person Can’t Afford A $400 Emergency Payment
The reality is that needing to replace both tires would be a financial catastrophe for most families.
I felt incredibly fortunate that for me it was simply an inconvenience thanks to having an emergency fund. In fact, our emergency fund was there for exactly this type of unexpected event.
Growing up in poverty, this type of repair would have likely cost my mom more money than she had. So it would have meant not getting it fixed until a couple of more paychecks arrived. But without having a car to get to work, she would have lost her job. It wouldn’t be a stretch to say it would have resulted in missing a month or two of rent payments.
This highlights why having an emergency fund is so critical. Today, I am going to explain what emergency funds are, how they work, how to create one, and how to use it to protect your family from a financial emergency.
What Is An Emergency Fund?
An emergency fund is nothing more than money set aside in case of an emergency. An emergency is a bill or unexpected expense that can’t be delayed. Like needing to fix your car so that you can go to work. Or paying for a medication that you need to stay healthy. Or paying for the unexpected funeral of a loved one.
Emergency funds are for true emergencies that cannot be predicted and need to be fixed ASAP in order for you to continue to work, eat, take care of family, etc. Any expense that isn’t an emergency should be budgeted for already.
An emergency fund is sometimes called a rainy day fund or emergency savings fund. Emergency funds are not specific types of accounts. You can’t go to your local bank or credit union and ask to open an emergency fund. It’s just any money that you have set aside and will not use unless it’s an emergency.
Some people think of their emergency fund as a minimum balance or a floor for their savings accounts, which they don’t allow themselves to dip below (unless it’s a last resort). I will dig into which types of accounts are great for this, and how much you should save, but first, let’s discuss why you even need one. Isn’t a credit card a good enough back-up source for cash? No!
Remember, joining your friends for dinner because your paycheck is late is NOT an emergency. I am talking about medical emergencies, broken-down cars, maintenance problems with your home, etc. Real emergencies.
Why Do I Need an Emergency Fund?
Life is unpredictable. It is full of amazing experiences, like when your favorite team wins the Super Bowl or you get that promotion you’ve worked so hard for. On the other hand, a lot of bad surprises happen too. Cars get towed, unexpected bills pop up, or you get sick on a hiking trip.
Most Americans don’t have $500 in savings. This means that an unexpected bill can set you back months or years if you start racking up credit card debt just to get by. Interest on a credit card can be more than 20%, which is freaking insane. Like, so insane you’d be set for life if you could loan money at those kinds of rates. Credit card debt is a slippery slope you need to avoid at all costs.
Emergency events often happen unexpectedly and give you no time to prepare. That’s when the emergency fund steps in.
Pop a tire on a huge pothole driving to work? The emergency fund can help cover the cost. An unexpected event can make a huge impact on your life. If your car breaks down and you are unable to cover the repairs, you may lose the ability to get to work and lose your job.
The point of an emergency fund is to protect you from extended hardship. An emergency fund will help you get back on your feet as quickly as possible.
Saving up a little bit of money each month can help protect you, your family, and your future. This is why saving an emergency fund should be your #1 priority. Even before saving for retirement. Retirement will be an afterthought if you are completely broke due to an emergency.
How Much Should I Set Aside in Emergency Savings?
Focus On Saving $1,000 ASAP To Get Started
How much you set in your emergency fund depends on your income and how much you spend each month. Early on you may only be able to set aside $120 by saving $10 each month for a year. Setting aside $40 each month can add up to nearly $500 after a year. This will put you way ahead of your peers, and is a perfect example of the effectiveness of a monthly budget.
If you depend on a car for your daily obligations (going to work, grocery shopping, etc.) you should set aside $1,000 as quickly as you can. Car repairs are often expensive and essential depending on where you live.
Next, Save 3 to 6 Months Of Basic Living Expenses
Basic living expenses are rent, groceries, utilities, minimum loan payments, etc.
Disability insurance can help you if you become disabled and cannot work. However, disability policies often do not start paying you for 3 months after you file your claim. If you have disability insurance through your job, look into how long the waiting period is before you would receive payments. Saving up enough money to cover your expenses during the waiting period is a good idea.
Not everyone is able to save up that much money in an emergency fund overnight, but the key is to save regularly. You should save the money in a different account than the one used for daily expenses. Leaving the money alone is just as important as putting it into the emergency fund so that it is still there for a true emergency.
It is also important to replenish the account after any emergency. The goal is to always keep the emergency fund at your target level or be working towards reaching it. This is true regardless of how much money you have.
How To Save Money
Now that you know how much you should save, you might be wondering how to even save up. You essentially have two options (working on both is the best idea): lower your expenses or increase your income.
Learning how to budget is the most important step in saving money. It will serve as your guide as you begin to learn about managing your money. Even once you have more money you’ll want to budget, so that you can accelerate your financial goals.
By setting a specific goal for your savings rate, you’ll have a good sense of your ability to save money.
Where Should I Keep My Emergency Fund?
Hopefully, you will not need to use this money very often (hopefully less than once every few months), which means you’ll have a healthy balance in your emergency fund. For that reason, you should aim to open a high-interest savings account. Traditional checking and savings accounts are not the best choices because their interest rates are basically 0%. These are banks like Wells Fargo, Chase, Bank of America, etc. The big dogs. Sadly, the big dogs don’t always play nice. Aside from low-interest rates, they often come with balance minimums and other requirements as a way to charge you a fee.
The last thing you want to do with your hard-earned money is to pay more fees!
Use A High-Interest Savings Accounts
If you’re going to be setting money aside, you might as well make as much money from it, and every penny counts. It sounds insane, but things add up, and over years of working, a single penny can compound into several pennies, which compounds into dollars, which then compounds to lots of dollars!
This is why a high-interest savings account is a wonderful place to save money! You could also consider using a no-penalty CD account if you prefer. You just have to make sure there’s actually no early-withdrawal penalty.
I Use An Online High-Interest Savings Account For A Few Reasons
These accounts tend to have better interest rates than the large national banks and sometimes even smaller local federal credit unions.
Try to find a savings account with at least a 1% annual interest rate. It is also critical to find a bank without minimum balance requirements or other fees for your emergency fund. Banks like CIT Bank, Ally Bank, or Marcus are great options for this. They offer interest rates that are WAY higher than traditional banks and have no monthly fees. Easy.
There’s no point in opening a savings account if the bank will take some of your money away in monthly fees. Another big advantage of online banks is that if you move you don’t have to worry about switching banks every time. I’ve moved to new cities periodically and not needing to worry about having a local bank is a huge plus.
Throughout all of my moves around the country, I kept the same online account for my emergency fund.
Don’t Use Credit Cards
Some people think that keeping a credit card on hand is good for an emergency. After all, a credit card is like a loan that you can access at any time. However, credit cards are extremely dangerous in emergency situations.
Consider the scenario where you lose your job. If you don’t have money saved and it takes you longer than expected to get a new job, you will begin to pay interest on your credit card debt. This will create a hole that will be extremely difficult to climb out of. You don’t want to make an emergency worse than it already is!
It’s okay to use a credit card in a pinch until you can withdraw money from your emergency savings account. Just remember to pay off the card in full and put it away until you are back on your feet.
Avoid Selling Investments Like Stocks To Pay For An Emergency Or Investing Your Emergency Fund In The Stock Market
If your only way to avoid living on the street is to withdraw money from your 401k, then obviously do it. But realize that in general, it’s a big no-no to sell your long-term investments if you can avoid it.
It can also be tempting to put an emergency fund into the stock market so that the money can grow. This is because if you go a couple of years without using the money you may begin to think that your money would be better off growing in the stock market. But this is riskier than it may seem.
Consider that the stock market lost roughly 54% of its value during the Great Recession of 2008-2009. If you were laid off or suffered a serious injury during that time, you potentially wouldn’t have enough money to cover your living expenses. It’s better to be safe than sorry when it comes to preparing for emergencies!
As a matter of fact, during times when the market drops, you are most likely to be laid off (think to the coronavirus pandemic as an example), which means that you will be selling your investments at the bottom of the market. Remember the old wisdom of buying low and selling high? Putting your emergency fund in the stock market increases the chance that your money won’t be there when you may need it most.
Where Do I Keep My Emergency Fund?
As of today, the interest rate I am getting from Capital One is 1.30%. There are no minimum requirements and no yearly fees.
Remember that this is a savings account so you need a checking account to access cash via an ATM. You can link your savings account to your checking account (does not have to be a Capital One checking account) to put money in or transfer it out. I like having the online checking and savings at the same bank so that I can move the money instantaneously to my checking if I need it to withdraw it from an ATM.
Capital One also has a large ATM network (they have ATM partners) so when you need to use the money, you can simply find a nearby ATM to get the cash if you also have a Capital One 360 checking account. Ultimately, I lived in cities that had Capital One locations making it convenient to stop in if needed.
I have literally never actually walked into the branch for anything. One thing to note is that you can’t make more than 6 withdrawals per month from savings accounts. This is true regardless of which bank you use. Emergency funds shouldn’t be withdrawn regularly so this shouldn’t affect you. However, if you think you’ll be taking money out a lot, stick with a checking account.
Other Great Options For Your Rainy Day Fund
Many employers have credit unions affiliated with them in addition to local credit unions near where you live. Be sure to check their rates as that might be more convenient for you. If I find another bank with significantly higher interest rates and no minimums or fees, I may switch there.
In general, the interest rates on savings accounts are going to be pretty low. The MOST IMPORTANT factor for your emergency fund is to find a bank account with zero monthly fees. The last thing you need when you are hurting for money is to be paying someone else fees.
If you have an emergency fund and are curious about what else you can do, check out our personal finance guide! It’ll help you prioritize personal finance decisions, so you can continue to rock them.
Camilo is a personal finance expert and the Co-Founder and CEO of The Finance Twins. I was raised in poverty by a single mother and had to learn everything about personal finance on my own. I have been featured on Forbes, Business Insider, CNBC, and US News. Earlier in my career, I worked as an investment banking analyst on Wall Street at JPMorgan Chase & Co., and I have an M.B.A. from Harvard University and a B.S.E. in finance from the Wharton School of the University of Pennsylvania.