An emergency fund is one of the basic pillars of financial security. When you have a stash of cash set aside to cover unexpected expenses, you can avoid costly problems like racking up credit card debt or pulling money from your retirement fund.
However, too many people don't have a solid emergency fund. Only around 60% of Americans say they have enough savings to cover a $400 unexpected expense, according to research from the Federal Reserve Bank.
Although not having an emergency fund can put your financial health at risk, the thought of establishing one can be overwhelming. Most experts advise saving enough to cover three to six months' worth of living expenses, which will likely amount to several thousands of dollars. If that sounds intimidating, there's good news: New research shows you might actually need much less than that stashed away in your emergency fund.
Your emergency fund: How much should you save?
Economists may have found the exact amount you should stash in your emergency fund: $2,467.
Researchers from the Federal Reserve Bank of St. Louis and the Universidad Diego Portales in Chile studied lower-income households (since this group of people is least likely to already have an emergency fund) to see how much money it takes to lower the risk of financial disaster in the event of an unexpected expense. They discovered that, for every dollar a household saves up to $2,467, it significantly lowers the risk of experiencing financial hardship (such as skipping paying rent or bills or not receiving necessary medical care) if an unexpected expense occurs. But for every dollar households save more than $2,467, it doesn't have the same effect -- meaning that saving more than that amount doesn't necessarily provide extra protection against financial hardship.
Of course, that's not to say that if you save $2,467 you're safe from every single financial obstacle that could be thrown your way. The research itself said that there's uncertainty in the exact amount, noting with 95% confidence that the number is somewhere between $1,814 and $3,011. Moreover, it's still always possible that you could face a significant unexpected expense that could quickly wipe out your emergency fund. However, the figure represents about one month's worth of savings for a typical low-income household -- well below the three to six months that most experts recommend.
Keep in mind, too, that researchers based this number on lower-income households, or those who fall into the bottom 30% of income distribution. Higher-earning households can struggle with emergency savings, as well, and if you have more expensive living expenses, you may need more than around $2,500 to be able to cover unexpected costs.
Building your emergency fund one dollar at a time
If you're struggling to save anything in an emergency fund, take a look at where your money is going to see if there's any room in your budget to make cuts. If you're not tracking your spending, it's easy to overspend on non-essential costs without realizing it -- making it feel like you're more strapped for cash than you really are.
Once you've found some extra money you can put toward your savings, make sure you're storing your cash in the right place. A high-yield savings account is one of the best places to establish an emergency fund because you're earning a relatively high interest rate, yet you can still withdraw the money whenever you need it. The best high-yield savings accounts earn interest rates of around 2% per year, which is far better than the dismal fraction of a percent you'll likely receive by putting your money in a checking account or standard bank savings account.
Some people may choose to forgo the emergency fund because they're too focused on other financial goals. You may be trying your hardest to save for retirement, for instance, and it might seem counterintuitive to change gears and start putting your money toward your emergency fund. So if you're facing multiple financial priorities, how should you balance them?
It helps to think about the consequences of not saving for each goal. Of course, not saving for retirement can lead to problems down the road. But what happens if you don't have an emergency fund and you're hit with a major unexpected cost? Do you rack up credit card debt, which can hurt your credit score and make it harder to save? Or perhaps you might pull the cash from your 401(k) or IRA, which might result in getting hit with an early withdrawal fee (plus you'll be sabotaging the hard work you've put into saving for retirement). Neither of those situations is ideal, but they could both be avoided with an emergency fund.
That's not to say that other goals, like saving for retirement, aren't important. But if an unexpected expense could potentially wreck your entire financial situation, it might be wise to prioritize your emergency fund, at least until you have a couple thousand dollars socked away. Then, once you know you're not risking going into debt or hurting your retirement savings if you face an emergency expense, you can go back to working toward your other goals.
Establishing a stash of emergency savings may not seem like the most crucial task on your priority list, but not having a rainy day fund could lead to a domino effect of consequences if you face a significant unexpected cost. But if you prepare for these types of expenses by setting aside a couple thousand dollars in savings, you can ensure these financial obstacles won't get in the way of achieving your goals.
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