An emergency fund is your first line of defense against high-interest debt - and a powerful tool to provide peace of mind
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- Emergency funds can prevent going into debt for unexpected expenses like a medical emergency, job loss, or family crisis.
- Most Americans generally need about six months' worth of living expenses saved in an emergency fund.
- To build one, you can trim money from your regular spending, or set up an automatic contribution into your emergency savings account from your bank or payroll company.
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About 78% of Americans admit they're living paycheck to paycheck to make ends meet, according to a survey by CareerBuilder. The same survey also reported that more than one in four workers do not set aside any savings each month and three in four workers say they are currently in debt.
"If you have little, or worse yet, no savings accessible to you when you need it, a job loss, family crisis, or medical emergency could be disastrous to your finances," says Chris Kowalik, founder of ProFeds, a nationwide support structure for financial professionals serving federal employees.
"Emergencies are bound to happen, and we often have no control over that," she continues. "However, what we do have control over is being financially prepared to handle it."
Having an emergency fund in place can provide peace of mind if a job loss or medical emergency occurs.
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Being unprepared can lead to debt
Despite the name "emergency fund," unforeseen expenses happen quite often.
"In other words, while I wouldn't exactly call a flat tire or unexpected home repair an emergency, they can certainly be rather expensive situation," says Matthew Frankel, a certified financial planner and personal finance expert at The Ascent. Having money in a readily-accessible place like a savings account allows you to take care of expenses like these without taking on high-interest debt.
"As an example, let's say that your car breaks down and needs $1,000 worth of repairs," continues Frankel. "If you don't have any emergency savings and put this on a credit card at 18% interest, and then pay $50 per month, you'll end up paying nearly $1,200 over the next two years."
And, if something else unexpected happens in the meantime, you'll have to add to your debt and interest expense. "It's not difficult to see how this can lead to a cycle of debt," Frankel says.
Most people need a 6-month emergency cushion
In general, experts say one should aim for three to six months of expenses in an emergency fund. Only 29% of adults have that much, according to the Bankrate survey.
"The key thing to remember is that something is better than nothing," says Frankel. "Even if you can build up a $500 cushion, you'll be in better shape than half of Americans. So, start by setting aside a small amount out of every paycheck - say $25 or $50. You'll be surprised how quickly it can build up."
To further illustrate, if $25 a week is set aside in an emergency fund, at the end of two years, you could have $2,600 saved. If that amount is doubled to $50 a week, your emergency fund can grow to $5,200. Put $75 a week in reserve, and you will yield $7,800.
Plus, if that money earns even modest interest in a high-yield savings account, which keeps your money easily accessible but earns up to 200x more interest than money stored in a traditional bank account, it can grow even faster.
The most important thing to start saving, no matter how you do it
As always, however, saving money is easier said than done.
When beginning to start an emergency fund, the first step is to free up some money to save. "One way to do this is to cut back on non-essential item such as eating out regularly or buying 'stuff' like clothes, shoes, or electronics that you don't really need," Kowalik says. That money goes straight into your emergency savings. And, until you hit that six-month mark, use any extra money you get from a bonus, pay increase, or monetary gift to help you reach your goal faster, says Kowalik.
Or, you can easily set up an automatic contribution from your paycheck to go straight into emergency savings, either through your bank once your paycheck clears, or through your employer's payroll company if the company offers that service. That way, you automatically create savings discipline, says Terry Dunne, senior vice president, managing director at Millennium Trust Company, and you don't miss the money because it gets diverted before you have a chance to spend it.
"As the account starts to grow, you'll probably feel a real sense of accomplishment," says Kowalik, "and you most likely won't even miss the things that you cut out of your spending,"
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