Everything You Need To Know About Emergency Funds
Some things you need to know about emergency funds: what they are, how big they should be, when to use them, and more.
Having an emergency fund is the bedrock of a good financial plan. When you have three to six months of your monthly income saved, you’ll have the financial freedom to focus on other important financial goals in your life like retirement or saving for a home.
But how do you create an emergency fund? Where should you keep it? In this article, we’ll cover those questions and how Betterment helps, using something we call your “Safety Net” goal.
What is an emergency fund?
An emergency fund. A safety net. A rainy day account. Whatever you call it, an emergency fund is a pool of money you save in case you are faced with a worst case scenario: losing your income entirely for some unexpected reason.
You should keep these savings for major emergencies like a major medical problem or losing your job.
But an emergency fund should not be used unless absolutely necessary. It should never be used for discretionary spending, like going out to dinner or a vacation. Think of those fire extinguishers that say “in case of emergency, break glass.” That is the feeling you should have when you go to withdraw from your emergency fund. If the expense isn’t essential, think twice before dipping in.
How does Betterment’s Safety Net goal help?
If your emergency money is not invested, you run the risk of decreasing your money’s value over time because of inflation. The aim of our Safety Net goal is to match inflation while lessening potential investment risks. Therefore, our recommended allocation for your Safety Net goal is 30% stocks.
With this as a base, you can begin to customize your safety net balance to match your situation.
Unfortunately, losing your job is one of the most expensive emergencies you are likely to face, so this is a good starting point for calculating the proper size of your emergency fund.
That means a good starting point for your Safety Net balance should be three to four months of expenses.
If you’re unsure what three to four months of your spending is, Betterment will calculate it for you using your gross income, zip code and research from the American Economic Association and the National Bureau of Economic Research.
If your income isn’t stable it can be a good idea to add a few months to your safety net. If you’re the sole/primary income earner, losing your job could be catastrophic to your family’s finances, more so than if your spouse also works. If that’s the case, consider increasing your safety net by a few months.
How To Save For Your Safety Net Goal
Building a financial safety net doesn’t happen overnight. However, with a little bit of planning and discipline, you can build your safety net quicker than you might think, by following these steps.
1. Clearly define your goal.
You want to have a clear target in mind. That means having a concrete dollar amount and a definite time horizon in which you want to reach it. This might be something like “I want to have $15,000 in 3 years.” This is how opening a Safety Net goal will look like in your Betterment account.
2. Let Betterment calculate your required savings.
Betterment will estimate how much you need to save per month to reach your target amount in your desired time horizon. This will depend on:
- Your target balance
- Your time horizon
- How much you already have saved
- The expected interest rate/growth rate of your account
Below is a screenshot of our goal forecaster to help you see how much you need to save per month to be on track for your emergency fund goal, and run what-if scenarios with different monthly savings, time horizons and target amounts.
3. Adjust your plan as necessary.
If you aren’t able to save that much, that’s okay. Nobody expects change to happen overnight.
It just means you may have to make some adjustments, like delaying your time horizon, diverting savings from other goals, adjusting your budget, or some combination of all of these. You can also use any extra income you get, such as a tax refund or end-of-year bonus to reach your goals.
4. Make saving automatic.
Setting up a regular auto deposit can help you stick to your savings plan because it reduces the effort required to save your money in the first place.
Betterment allows you to choose the amount and frequency of your auto deposit, and even skip an upcoming auto deposit in case funds are tight.
What are the benefits of opening a Safety Net goal?
In case you aren’t already convinced, here are three key benefits of having a financial safety net.
- Avoid unnecessary debt.
- Peace of mind.
- Financial flexibility
You should plan your emergency fund into your financial plan as a top priority.
Opening a safety net goal ensures that your emergency fund is separate from your other goals, is low-risk, easily-accessible, and has competitive earnings/low fees.