No matter how well you manage your money and stick to a budget, you can't control when unexpected expenses will pop up. Whether your car suddenly won't start, the dog needs surgery, or you lose your job, these emergencies can cost thousands of dollars -- and most people don't have that kind of cash lying around.
Many Americans don't even have a few hundred dollars to spare for emergency expenses, a new report from the Federal Reserve Bank found. When asked how they would cover a $400 unexpected expense, only 61% said they could pay for it with their savings. More than a quarter of respondents said they'd need to borrow money or sell something to come up with the cash, and 12% said they wouldn't be able to cover the expense at all.
Because unexpected expenses will inevitably arise, it's important to have a healthy emergency fund to cover those costs.
Protecting your future with an emergency fund
An emergency fund not only helps pay off unexpected expenses quickly, but it also helps protect your financial future. If you're struck with a big bill you can't pay, you may have to rack up credit card debt, borrow from your retirement fund, or take out a loan to cover the costs.
Those scenarios, though, can lead to a domino effect of consequences. Credit card debt is notoriously difficult to pay off because of its sky-high interest rates, and you could end up paying hundreds or even thousands of dollars in interest alone. For instance, say you had a $1,000 emergency expense that you put on a credit card with an 18% APR. If you made payments of $50 per month, it would take around two years to pay off that debt, and you'd pay around $200 in interest alone.
Taking the money from your retirement account is also a risky idea because it can throw off your entire retirement plan -- plus you might get hit with penalty fees. If you withdraw cash from your 401(k) or traditional IRA before the age of 59 1/2, you'll have to pay a 10% penalty on the amount you withdraw. You can take out a loan, but even relatively small loans could have long-term financial consequences. Many retirement accounts don't allow additional contributions aside from loan repayments, so you can't continue saving until the loan is paid off. You're essentially pressing pause on your retirement saving, and because your money grows faster the more time it has to build, it may be difficult to make up for lost growth opportunities.
A solid emergency fund can cover unexpected expenses so you can avoid dipping into your retirement savings or taking on additional debt, and it's easier than you may think to establish one.
Building a robust emergency fund
Generally, you should aim to save enough to cover three to six months' worth of living expenses. Keep this money separate from your day-to-day checking account, because you want to ensure it's being reserved for emergency expenses. If you throw all your money together into one account, it's tough to avoid dipping into your savings for everyday expenses.
A high-yield savings account is a good choice for an emergency fund, because it's less risky for short-term needs than investing the money, and you can also withdraw your savings quickly and without any financial consequences. The best high-yield savings accounts have interest rates of around 2% or more per year, which is far better than the dismal 0.01% interest rate that many traditional savings accounts offer.
As you're building your emergency fund, don't forget about saving for retirement. Because retirement saving is easier the earlier you start, it's best to contribute at least a little each month to your 401(k) or IRA as well as to your emergency fund. It may take a little longer to build a solid emergency fund, but it will be easier to reach your long-term retirement goals if you save consistently.
It may seem as if there are too many financial priorities and not enough money to go around. If you're struggling to make ends meet, saving for an emergency fund may feel like just another goal you can't afford. But in reality, you can't afford not to create an emergency fund. By having a designated fund just for unexpected expenses, you can avoid future financial consequences and save more money in the long run.