Emergency funds can provide protection and peace of mind

Life has a way of throwing us financial curveballs – whether it's an unexpected injury or a loss of income. But if you’re prepared, you can help prevent these events from depleting your savings or putting you into debt. An emergency fund can protect you and your finances from the unknown.

First, let's break down what an emergency fund is and how to build one.

What is an emergency fund?

An emergency fund is a cash reserve set aside to cover any non-budgeted expenses that may arise. Imagine that your car breaks down and you need to buy a new one. Or your refrigerator randomly breaks and you need a replacement. An emergency fund is a way to pay these expenses off without cutting into your savings. Even something as disruptive as being laid off is not as catastrophic to your finances if you have cash in reserve. Emergency funds can be used for small and large unplanned bills and expenses that aren’t part of your normal monthly spending.

How much do you need?

When it comes to emergency funds, a good rule of thumb is to store three to six months of living expenses in the bank. Where you fall in that range depends on your lifestyle and finances. Reasons one might choose to err on the side of saving more versus less include being retired, working in an industry where layoffs or furloughs are common and having an unsteady income or money tied up in investments. A larger emergency fund is also important during recessionary periods or in an environment with high unemployment.

How do you build an emergency fund?

There are different ways to build an emergency fund. The first approach is to focus on setting aside money from each paycheck. A helpful tip to accomplish this is to choose a specific savings goal to keep yourself motivated and accountable. Then create a system to make regular contributions. Most banks or paycheck services offer automatic transfers to your savings account. These curb the risk of forgetting to save the money or spending it discretionarily. It’s helpful to aim to save a specific amount each pay period. Don’t forget to monitor your progress regularly, as you may find that you can afford to save more than expected.

Or, if you are expecting bonuses or a tax refund, consider using these payments to kick start or bolster your emergency fund. This may mean skipping a vacation or not purchasing the newest flat screen, but it will buy you peace of mind over the long term. Alternatively, you could spend a portion of these one-time windfalls and save the rest.

Why is an emergency fund important?

There are several reasons why an emergency fund is important. For starters, it provides you a financial safety net. If you have money set aside for emergencies, you‘ll alleviate your risk of going into debt to cover an unexpected expense. Without a fund in place, you may have no choice but to put emergency expenses on a credit card. If you don’t pay it off in a month, you accrue interest, making it difficult to pay down your debt.

Tapping into retirement savings is another way people without emergency savings may need to cover unexpected expenses. However, that, of course, is not ideal. Having money set aside for retirement is important, and you may be subject to a penalty if you pull the funds from a tax-advantaged retirement account early. In addition, you’d lose the long-term benefit of compounding, which occurs when the interest on your savings earns interest.

Even relying on friends or family to help with an emergency is not ideal. Borrowing money from friends and family could negatively impact your relationships.

Beyond financial stability, having an emergency fund provides something invaluable: peace of mind. Knowing you’re covered in the case of a costly emergency relieves stress in the worst-case scenarios.

Where should you put your emergency funds?

Your emergency fund should be liquid and accessible. However, it shouldn’t be so easy to access that you are tempted to spend it on non-emergencies.

A bank or credit union account is one of the safest places to store your money. Keeping cash on hand can sometimes seem like the safest storage method. However, money stored in bank account is insured up to a certain amount. To boot, it often accrues some interest – albeit small.

Another option is investing. While investing involves risk, including the potential loss of your funds, growing your wealth with investments can provide a financial buffer that could be used in addition to your savings account. Consider different types of investments that are easy to access. Exchange-traded funds (ETF), mutual funds and dividend-bearing investments are all options to consider. You can always connect with a financial professional first to learn about your investment options.

Even a little bit counts

If you don’t think you can save enough to cover three to six months of expenses all at once, you’re not alone. For many people, three to six months of expenses is a large amount of money. If that’s the case, you can slowly build up your emergency fund by saving smaller amounts. Even saving a small amount per week in an emergency fund is helpful in the long run. Eventually, with consistency and discipline, you’ll still be able to hit your goal.

There are so many unknowns in the economy and in life, which is why an emergency fund is a key part of a sound financial strategy, supporting your sense of financial stability and peace of mind.

If you’re not sure where to begin, contact a J.P. Morgan advisor to assist with your financial strategy.

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