How to start an emergency fund
Figuring out how much you should save is the first step. Start by reviewing your budget: List your monthly expenses, and calculate the total amount you need to live on.
Make sure to include housing, transportation, groceries, utilities, loan payments and any other recurring expenses. But don't include discretionary expenses like entertainment, retail shopping and eating out.
Conventional wisdom says you should have an emergency stash that covers three to six months' of those essential costs. But these days, even that might not be enough. So, once you have an accurate monthly figure, multiply it by 12. The result is your emergency fund goal.
Next, look at your current savings and determine how much (if anything) you're setting aside for emergencies. Subtract that amount from your goal to find how much you still need to save.
Where to keep your money
It's best to use a separate account for your emergency fund. But what kind?
Today's historically low interest rates on traditional savings accounts—a minuscule 0.6% on average in August Opens in new window—could bring stuffing cash under a matress back into vogue. Happily, you can typically find higher payouts from online banks than their brick-and-mortar cousins. (Websites like Bankrate.com and NerdWallet.com can help you shop.)
Also, not all emergencies are equal—a broken water heater in winter might mean paying a plumber within hours, while a major car repair could wait for weeks. So, to inch up your earnings, consider keeping some of your stash in relatively safe places that are less "liquid" but earn more—for example, a conservative investment fund that holds short-term Treasury bonds (where your money could take several days to access) or a bank CD (where you might have to wait months to withdraw without losing earnings or paying a penalty).
To build up your fund, set up automatic, monthly transfers from your regular savings or checking account. Look for perks your bank may offer that can perk up your savings, such as a "round-up" feature or reward points on transactions with credit or debit cards linked to your account. Also, if you get a big tax refund each year, understand you're overpaying Uncle Sam (or your state) with each paycheck. So, consider changing exemptions on your federal or state W-4 form to get more take-home pay—and move the extra money to your emergency fund.
Build your fund wisely
It may be tempting to withdraw money from a retirement account to add to an emergency fund. But pulling funding from your future is dangerous. In fact, you should do so only if you face an emergency and have no other way to cover expenses. Due to COVID-19, the federal government has made that easier by relaxing rules on hardship withdrawals from retirement accounts. For example, if you take "coronavirus-related distributions Opens in new window" in 2020, the usual 10% early-withdrawal penalty won't apply you'd still owe income tax, but you can pay it over three years. You can also borrow up to 100% or $100,000, whichever is lower from your retirement plan.
But minus an actual emergency, look for other ways to save. For example, if you have a mortgage, you may be able to use money from a "cash-out" refinance to fill your emergency fund. But because you'd be borrowing more—and possibly paying fees for the privilege—you should do this only if you don't plan to move for at least five years or so, and you already have significant equity in your home.
If that's not an option, you may have to cut back on discretionary spending to free up money for emergencies. Also consider funneling windfalls like tax refunds, work bonuses and, yes, government stimulus checks into your rainy-day bucket.
Maintain a proper balance
You may wonder how to balance saving for emergencies with saving for retirement, paying down debt or saving for a child's college education. Think of the emergency fund as the first rung on the financial ladder. If you try to skip it, you'll be in a more precarious position.
Everyone's situation is different, of course. But in general, until your emergency fund is up, running and (at least nearly) full, you should make the minimum payments on your loans, skip the 529 college contributions, and even save less for retirement.
Monitor your needs
As your circumstances change, you may need to increase your emergency fund. For example, new homeowners should save more to cover surprise home-related expenses. New pet owners may also want to save more for surprise vet bills.
If your regular expenses rise, your emergency fund goal should as well. After having a baby, for instance, you may need to beef up your just-in-case account to cover costs like day care.
Sit down every few months and examine your monthly budget to determine if your emergency fund still meets your potential needs—and make adjustments if not. And of course, if you do have to tap your emergency savings, try to build them back as quickly as you can.