As financial futures become more precarious, the need for emergency savings becomes all the more apparent.
The common rule of thumb was to save three to six months’ worth of expenses —but that may no longer be enough.
“The rule of thumb went right out the window when things hit the fan,” said Jason McGarraugh, financial advisor at Neal Financial Group. “No one really prepares to lose their job for three, six, nine months. It’s usually out of the blue. That’s why you need to be prepared.”
While it isn't possible to plan ahead for this pandemic, you can protect yourself from future economic downturns. Here's how you can build a 12-month emergency savings fund.
What is the right amount of emergency savings?
There’s no one-size-fits-all emergency plan. How much you should save depends heavily on your current financial picture, family situation and future goals. For example, an individual married with three kids should plan for a substantially larger emergency fund than an unmarried individual with no kids.
Essentials include things like housing costs, medical expenses, food, utilities and child care, said McGarraugh. Once you have an idea of your monthly costs, you can calculate your 12-month emergency fund number.
Tracking your spending and keeping a budget is key to understanding how much it costs for you to live. McGarraugh recommends using a spending diary and manually tracking your spending over a month.
“Your essential spending is not every single thing you buy,” he said. “It is the minimum amount you could live on for a set amount of months.”
Where is this fund supposed to go?
An emergency can happen anytime, so keeping your money readily available is essential. But not too available: Your savings should be separate from your checking account to curb impulsive spending.
Traditional savings accounts are an option, but can actually lose value over time because their low interest yields don’t keep up with inflation. Enter the high-yield savings account, which pays a higher interest rate on deposits than a traditional savings account. The average national annual percentage yield on traditional savings accounts is 0.09%. Many high-yield savings accounts have APYs around 1.5% — a big difference in return.
Keep in mind that transfers from a high-yield savings account can take a few days, so you may want to keep a portion of your emergency money in a more accessible place, said Dennis Nolte, certified financial planner and vice president of Seacoast Investment Services.
“You need to keep your money fairly liquid,” he said. “If you lose your job or have a medical emergency, you’re not going to be able to wait.”
Or, you could even invest your savings: Some investments are (almost) entirely risk-free, making them a good place to grow your savings without the potential for complete loss. One option is a money market fund, which are pools of short-term bonds, certificates of deposit and other low-risk investments that are sold by brokerage firms. These funds are typically pretty safe, and you can usually take out your money anytime without being penalized. Other accounts, like a certificate of deposit, charges you for removing money before a specific amount of time has passed. If you’re looking for growth, consider investing strategies that better match your goals.
If you’re not sure where to start, here’s a step by step guide to building a year’s worth of emergency savings.
Steps to build a 12-month emergency fund
- Calculate how much you need to save. Tally up essential expenses and multiply them by the amount of months you want to save.
- Set a goal. Breaking down your goal into manageable steps will make building a year-long emergency fund less daunting. Figure out what saving schedule works for you and commit to contributing the funds you’ve set aside in your budget for emergency savings until you reach your goal.
- Consider making small changes … Cut back on small purchases — anything from a daily coffee habit to an unused subscription. Or go mobile: Some financial apps invest your spare change from daily purchases, which can earn you money over time.
- … and big money moves. This could mean everything from downsizing your home to ditching the second car, if possible.
- Make savings automatic. Set up automatic transfers to direct funds into your savings account. You can designate a certain amount of your paycheck to go into savings, taking the guesswork and scheduling out of the equation.
- Save your tax refund (and other windfalls). Whenever you receive income beyond your usual paycheck — this includes tax refunds, or an inheritance — you can use it to beef up your emergency savings fund and get closer to your goal. Instead of splurging, put your windfall to good use.
- Adjust as needed. Check in after a month or two. Are you on track to meet your goal? If not, consider adjusting to add more. Revisit your emergency fund during major life events, like marriage or moving to a new city — or a pandemic.
Emergency funds exist to protect you against the unexpected. If you’ve recently tapped your fund, here’s how to build it back up.
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Image: Nastia Kobzarenko