Why you need an emergency fund and how to build it

Part of our build your own financial plan series

Photo of a dog whose owner could afford to pay for their surgery because they had an emergency fund.

This is the year you’re working on a financial plan. (Hooray!) You’ve set your goals, budgeted to fund them, and reviewed your tax strategies to potentially keep more of what you earn. Your next step is to set up an emergency fund.

All the planning in the world won’t help if life throws you a curveball and you’re not prepared financially. Ask yourself a few questions:

  • Would a $500 expense throw off your budget in a big way?
  • Would losing your job force you to withdraw your 401(k) savings to pay the bills until you find employment?
  • Would the expense of an unexpected surgery on your dog (poor baby!) land on your credit card? How about if you blow the engine on your car? 

If you answered yes to any of those questions, you need an emergency fund.

How much do I need?

Set mini-goals. Start by saving $1,000. Then add to it until you have one month of expenses. Your ultimate goal is to set aside 3 – 6 months of your expenses. Use an emergency fund calculator for an estimate of how much that will be for you.

You may want to save more than 6 months of expenses if you’re the sole breadwinner or have an unpredictable income.

If you’re just getting started, don’t get hung up on the big number. The important thing is to just get started.

How to know if it’s an emergency expense

What does an “emergency” mean to you? It can vary by person, but here’s a good rule of thumb. Ask yourself: Is it unexpected, unavoidable and/or urgent? For example:

  • Unexpected: You’ve lost your job and need to pay the bills.
  • Unavoidable: It costs more to fix your dead refrigerator than to buy a new one.
  • Urgent: Your dentist just recommended you get two new crowns (not the kind that goes on your head).

What it’s not for—well, that includes stuff like a new sofa. Or tickets to a pro football game. Or a new motorcycle. Those aren’t emergencies.

Where should I put the money?

Keep your emergency fund in a bank account that’s liquid and accessible. But not too accessible. Meaning, put the money in a separate savings account that you can access online, but not from an ATM. (So you’re not tempted to withdraw it. You know—out of sight, out of mind.)  

Look for a high yield savings account with minimum balance requirements. You can compare online bank savings and money market rates.

Tip: using your emergency fund versus a credit card or a loan

Unless you have a zero balance on your credit cards, it’s best not to “finance” your emergency by adding to your debt. (And even if you have a zero balance, make sure you read a card’s fine print before you go this route to cover an emergency.) 

If you take out a loan, you’ll likely pay interest, fees, and maybe even penalties, which is a drain on your money.

And remember if you do need to take money out, start putting some back in so you can cover the next emergency.

How do I get started?

Here are 2 options to fund your new emergency fund.

  • Automate it. Have money direct deposited from each paycheck into a savings account. If you set aside $25 a week, at the end of 2 years you could have $2,600 saved.
  • To build it faster, transfer money from a bonus or tax refund. Plus, if you have a surplus of cash at the end of a month, add that, too. (Those dollars are meant for goals like this.)   

Having funds for an emergency can take a huge weight off your shoulders when you have a surprise expense, making it more of an inconvenience to deal with than a financial hardship.

Next steps

The subject matter in this communication is educational only and provided with the understanding that Principal® is not rendering legal, accounting, or tax advice. You should consult with appropriate counsel or other advisors on all matters pertaining to legal, tax, or accounting obligations and requirements.

Insurance products and plan administrative services are provided by Principal Life Insurance Company. Principal Funds, Inc. is distributed by Principal Funds Distributor, Inc. Securities are offered through Principal Securities, Inc., 800-547-7754, member SIPC. Principal Funds Distributor, Principal Securities and Principal Life are members of the Principal Financial Group®, Des Moines, Iowa, 50392.