No matter where you are with your debt—confidently on top of it, aggressively paying it down or trying to figure out how to make the minimum payment every month — there’s another financial goal you should keep in mind: an emergency fund.
Regardless of how careful you may be with your finances, you will encounter unplanned expenses. Your car breaks down; you need to take an unexpected trip; or, worse yet, you lose your job—these are all situations you may not have accounted for in your budget. An emergency fund gives you financial resilience, so you can handle unplanned expenses without jeopardizing your financial stability or increasing your debt.
An emergency fund helps you avoid costly financial decisions.
If you’re not prepared, the repercussions of an expense you haven’t budgeted for could be significant. You may be tempted to take a retirement plan loan or to dip prematurely into your retirement savings, both of which can have negative financial consequences. Or you may incur additional credit card debt, which is a very expensive way to finance unplanned expenses and can throw your debt-management efforts off track.
How much should you set aside?
The rule of thumb is to save three to six months of living expenses. These include basic costs such as food, housing, transportation and debt payments. You may want to save more if you have dependents relying on you or if your job situation is less predictable.
How can you get started?
Set up a separate high-yield savings account that is dedicated to unplanned expenses. Then, create an automatic transfer from your main account so that every time you receive a paycheck, part of it will help fund your emergency account. Consider adding to your fund whenever you receive a windfall, such as a tax refund. There are even apps that can round up purchases to the dollar and transfer that “change” to your emergency fund account.
Should you prioritize paying down debt or creating an emergency fund?
Both tasks are important. Don’t pay less than the minimum payment on any debts just to contribute to your emergency fund, but if your minimum payments are manageable, then build your emergency fund while you are paying down debt. For example, until you have at least three months of emergency savings, consider putting 50% of your available funds toward extra debt payments and 50% toward your emergency fund.
When should you use your emergency fund?
Many people plan to use emergency savings for unexpected situations, such as:
- Medical expenses not covered by insurance
- Job loss
- Essential home repairs, like a furnace failing
- Major car repairs
Some people like to have a fund that can cover unplanned financial opportunities as well, such as an unexpected purchase or travel opportunity. In that case, consider saving more in your fund or establishing another financial goal with a dedicated account to save for that vacation, celebration or big purchase.
Saving for unplanned expenses in a dedicated account is one of the best strategies you can use to gain the financial resilience that will support your long-term financial success.