3 keys to building an emergency fund

I recently received a call from my adult daughter. She had a financial question and wanted me to weigh in. It was a pleasant surprise. Like many parents, there were years when I wondered if she’d ever ask for my opinion again.

I talked her through the issue and debated whether to bring up another financial topic that’s close to my heart—emergency savings.

I’ve seen tough financial situations that were eased by using cash savings and others that were aggravated by a lack of funds. The current uncertainty in the economy points to the importance of having this type of savings buffer.

When I work with clients, I encourage them to create an emergency fund. Here are 3 key strategies I share to get them on their way.

1.    Start now (if you can)

The current economy has put many people in a position where they need to draw on their savings because of loss of income. If you or someone you know is dealing with financial challenges right now, here’s information on making it through an income shock.

For those who haven’t experienced a drop in income, this is an opportunity to save more aggressively for financial challenges that may arise in the future.

Spending less got a little easier for many people when states started mandating lockdowns. Many of us are working from home. We were forced to skip haircuts, and we cut down on other nonessential purchases.

A focus on saving is truly needed. In 2018, when the economy was strong, the Federal Reserve published a study finding that over 40% of Americans would have trouble handling a $400 unexpected bill. That may not be the case anymore. The U.S. Bureau of Economic Analysis reported Americans hit a personal savings record of 33% of income in April 2020.

Even if you’re not in a position to spend less, this still may be a good time to start your emergency fund. Like all investing, getting started is often the biggest hurdle. Consider using the same strategy that helps boost retirement plan savings: Automatically divert a portion of your paychecks into a savings account or money market fund.

2.    Know what you’re saving for

It’s tough to stay motivated to save. One trick: Know what you’re saving for. Then set short-term goals and track your progress. For most people, a general emergency fund serves as a catch-all for unexpected financial situations, which can range from a $500 home repair to an extended job loss.

Instead of grouping everything together, consider 2 different potential needs:

• Spending shock. This comes from unexpected expenses, such as a home repair or medical bill. I encourage all my clients to save for these expenses in a savings account or money market fund. A good initial goal is $2,000, but some people may need to save more. Many of my retired clients keep a large cash cushion in case of unexpected medical expenses.
• Income shock. For most people, an income shock is a bigger concern. This refers to the financial hit of a job loss or business failure. For an income shock, we generally recommend keeping 3 to 6 months of expenses in an easily accessible account. This is tougher, so it’s a good idea to start by setting shorter goals: 1 month’s expenses, etc. One of the most effective strategies to reduce the impact of an income shock is keeping your core expenses in check—or lowering them if possible. For example, keep debt on cars and houses as low as possible. That way, you don’t need to save as much.

While saving for a spending shock is fairly easy, most people don’t want to think about having to cover income from a job loss. But it’s worth it. Having enough savings to cover 6 months of expenses can give you a sense of financial peace and security that many people will never experience.

3.    Keep your money in the right type of account

The next step is to decide where to stash your money. Clients often ask which Vanguard fund is best for emergency savings. For the spending shock portion, there’s no question. Keep it in a money market fund or savings account. That way, it will be easy to tap and low-risk.

When it comes to the 3–6 months of living expenses you’ll need for an income shock, it’s important to keep your money accessible, while also giving it a chance to grow. That means you should keep it in an account that won’t charge you penalties or place restrictions on withdrawals but will allow you to invest in assets that may generate a return. In a recent research paper, Break glass in case of emergency, we analyzed different account types and whether they’re appropriate for emergency savings. Here’s a quick glance of the best places to save for both types of emergencies:

Making it work

Like I said, the hardest part about saving is getting started. So here’s my challenge for you: Beginning with your next paycheck, commit to paying yourself first.

As a financial advisor, I work with clients to help them develop a budget, evaluate their spending needs, and understand their long-term goals. Whether you seek the help of an advisor or do it on your own, it’s important to have a plan.

During the call with my daughter, I gave in to the urge to ask her if she had enough savings for emergencies. Happily, she didn’t revert to her teenage self when I offered advice.

Instead, her response made me proud: “Yes, Dad, we’ve got that. We’re prepared.”

Notes:

• All investing is subject to risk, including the possible loss of the money you invest.
• We recommend you consult a tax or financial advisor about your individual situation.

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