How to create and build an emergency fund

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Imagine facing a car repair, medical bill, or job loss without any savings to fall back on. According to a recent Red Ventures survey, only 44% of Americans would be able to pay an emergency expense of $1,000 or more from their savings. 

Building an emergency fund is crucial to navigating financial challenges without derailing your long-term goals or forcing you to rely on high-interest debt.

We'll walk you through the step-by-step process of creating and maintaining your emergency fund, so you can build your own financial safety net and achieve peace of mind.

Why you need an emergency fund 

Before diving into the nuts and bolts of building an emergency fund, it's essential to understand why having one is so critical. Here are three key reasons. 

Unexpected expenses

Life is full of surprises, and not all of them are pleasant.

"An emergency fund is there to protect you if you lose your job, have a medical issue, home issue, or have any type of emergency," explains Jay Zigmont, PhD, certified financial planner and founder of Childfree Wealth. 

Without an emergency fund, these costs can derail your budget. Consider these statistics:

• The average cost of a car repair is $550
• A trip to the emergency room can cost an average of $2,700
• Replacing the roof of your home can cost an average of $21,000

An emergency fund creates a buffer to absorb these costs. That way, you won't have to rely on credit cards or loans, which can lead to long-term debt and financial instability.

Job loss or income reduction 

Layoffs, company restructurings, and other unforeseen circumstances can lead to a sudden loss of income. Without an emergency fund, a job loss can spiral into financial catastrophe, forcing you to make difficult choices between paying rent, buying groceries, and keeping the lights on.

An emergency fund provides a cushion during periods of unemployment, allowing you to cover your essential expenses while you search for a new job. This can help reduce stress and give you the time you need to find the right opportunity.

Avoiding debt 

When faced with an unexpected expense or income disruption, many people turn to credit cards or loans to bridge the gap. While this can provide temporary relief, it can also lead to a cycle of debt that's difficult to break free from. Credit card debt can quickly snowball, leaving you with a much larger burden than the original emergency.

Having an emergency fund allows you to avoid taking on debt during tough times. Instead of paying interest to creditors, you can use your own savings to cover expenses and get back on your feet.

How much should you save in your emergency fund? 

Now that you know why having an emergency fund is so important, the next question is: How much should you save? The answer will depend on your financial situation — but here are some general guidelines. 

Assess your monthly expenses 

The first step in determining your emergency fund target is to get a clear picture of your monthly expenses. 

“I always say you can't manage what you can't measure, so in order to start building an emergency fund, you first have to know where all of your current money is going,” says Taylor Kovar, a certified financial planner. “This can be as simple as looking through your bank and credit card statements and finding areas to cut back on or services to reduce.”

Make a list of all your essential costs, such as:

• Rent or mortgage payments
• Utilities (electricity, water, gas, internet, phone)
• Groceries and household supplies
• Transportation (car payments, gas, public transit)
• Insurance (health, car, home, life)
• Debt payments (student loans, credit cards)
• Childcare or education expenses

Once you have a complete list, add up your total monthly expenses. This will give you a baseline for how much you need to cover each month in the event of an emergency.

Set your emergency fund target

The general rule of thumb is to save enough to cover 3-6 months' worth of living expenses. For example, if your monthly expenses are $3,000, you should aim to save between $9,000 and $18,000 in your emergency fund.

However, the exact amount you should save will depend on several factors, including:

• Job stability: If you work in a volatile industry or are a freelancer, you may want to save more, says Zigmont. 
• Health: If you or a family member has a health condition that requires ongoing medical care, you may need a larger emergency fund to cover potential expenses.
• Dependents: If you have children or other dependents, you'll need to factor in their expenses and potential care costs in the event of an emergency.

Your emergency fund target should be based on your individual circumstances and risk tolerance. It's better to err on the side of having too much saved than not enough.

Start small and build over time 

If you're starting from scratch, the idea of saving several months' worth of expenses can feel overwhelming. Remember, you don't need to reach your goal overnight. The key is to start small and build your savings over time.

Begin by setting a realistic monthly savings target based on your current income and expenses. Even if you can only save $50 or $100 per month, it's a start. As your situation improves, you can gradually increase your contributions until you reach your goal.

6 steps to building your emergency fund 

Ready to start building your emergency fund? Here's a step-by-step guide to help you get started:

1. Set a clear savings goal 

So you have your overarching emergency fund number. Begin by setting a specific savings goal based on your emergency fund target. Break this goal down into smaller, achievable milestones to help you stay motivated and track your progress.

For example, if your goal is to save $10,000 in your emergency fund, you might set milestones like:

• $1,000 saved in 3 months
• $2,500 saved in 6 months
• $5,000 saved in 1 year
• $10,000 saved in 2 years

2. Create a budget and track your spending 

To free up money for your emergency fund, you'll need to take a close look at your current spending habits. Create a budget that accounts for all your income and expenses. Look for areas where you can cut back or eliminate unnecessary costs.

Some common areas to consider include:

• Dining out or ordering takeout
• Subscriptions and memberships you don't use regularly
• Cable or streaming services
• Impulse purchases or shopping sprees

Use budgeting tools or apps to help you stay on track and monitor your progress. Many banks offer free budgeting tools, or you can use a standalone budgeting app. 

3. Automate your savings

One of the most effective ways to build your emergency fund is to automate your savings. Set up automatic transfers from your bank account to your emergency fund each month, so you're saving without having to think about it.

Treat your emergency fund contribution like any other bill or expense, and make it a non-negotiable part of your budget. By paying yourself first, you'll be less likely to spend that money elsewhere.

4. Find ways to boost your income 

While cutting expenses is important, there's a limit to how much you can reduce. That’s why you should look for ways to boost your income and dedicate that extra money to your emergency fund. Some ideas include:

• Taking on a side hustle or freelance work
• Selling unused items online 
• Asking for a raise or looking for a higher-paying job
• Renting out a spare room or parking space

5. Make the most of windfalls 

Throughout the year, you may receive extra money in the form of tax refunds, bonuses, or gifts. Instead of using this money for discretionary purchases, consider dedicating a portion (or all) of it to your emergency fund.

While it can be tempting to splurge on something fun, remember that building your emergency fund is an investment in your long-term financial security. By using windfalls to boost your savings, you can reach your goal faster and with less overall effort.

6. Review and adjust your plan 

Building an emergency fund is not a one-time event but an ongoing process. As your financial situation changes over time, be sure to review and adjust your savings plan.

For example, if you receive a raise, consider increasing your emergency fund contributions to match your new income level. 

If you experience a financial setback, such as a job loss or unexpected expense, don't be discouraged if you need to temporarily reduce your savings or even dip into your emergency fund. The key is to get back on track as soon as possible and continue working towards your goal.

Where to keep your emergency fund 

Choosing the right account for your emergency fund is crucial to ensure that your money is accessible when you need it while still earning some interest. Here are some options to consider:

High-yield savings account 

A high-yield savings account is one of the best places to keep your emergency fund. These accounts typically offer higher interest rates than traditional savings accounts, allowing your money to grow over time.

The best online savings accounts are offering rates as high as 5.00%, compared to the average of 0.58%. 

Look for accounts with no monthly fees, no minimum balance requirements, and easy access to your funds when you need them. 

Money market accounts

Money market accounts combine features of checking and savings accounts. These accounts typically offer higher interest rates than traditional savings accounts but may require a higher minimum balance to avoid fees.

Money market accounts also often come with check-writing privileges or a debit card, which can make it easier to access your funds in an emergency.

Certificates of deposit (CDs)

If you have a larger emergency fund and want to earn a bit more interest, you might consider using a short-term CD for a portion of your savings. CDs typically offer higher interest rates than savings accounts but require you to lock up your money for a set period of time (usually three months to five years).

To maintain accessibility, you can use a laddering strategy, where you divide your emergency fund into several smaller CDs with staggered maturity dates. As each CD matures, you can either reinvest the funds or keep them in a more liquid account, depending on your current needs.

Regardless of which type of account you choose, be sure to keep your emergency fund separate from your everyday bank accounts. This will help you avoid the temptation to dip into your savings for non-emergency expenses and ensure that the money is there when you need it most.

Maintaining your emergency savings

Once you've built your emergency fund, it's important to maintain it over time. Here are some tips to help you stay on track:

• As your financial situation changes, your emergency fund needs may change as well. If your expenses increase or you’re planning on taking time off work, consider increasing the size of your fund to maintain an adequate safety net.
• If you do need to use your emergency fund for an unexpected expense, make a plan to replenish it as soon as possible. Dedicate as much extra cash as possible to rebuilding your savings until you reach your target balance again.
• It can be tempting to dip into your emergency fund for non-emergency expenses, like a vacation. But remember, the purpose of this fund is to protect you when unexpected expenses arise, not to fund discretionary spending.

The bottom line 

Building an emergency fund is one of the most important steps you can take towards financial security and peace of mind. By setting a clear savings goal and automating your savings, you can create a safety net that will help you weather life's challenges.

Remember, the key to success is to start small and be consistent. Even if you can only save a little bit each month, those small contributions will add up over time. And if you do need to use your emergency fund, don't be discouraged. The fact that you had savings to fall back on is a testament to your financial preparedness.

Editorial disclosure: Opinions expressed are author's alone, not those of any bank, credit card issuer, or other entity. This content has not been reviewed, approved, or otherwise endorsed by any of the entities included in the post.