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What is an emergency fund?

Saving is an important part of overall financial health. We need to save for retirement, higher educuation, to purhcase a home and, we should save for a rainy day. That rainy day fund is an emergency fund - there when you need easy, unplanned access to funds. Setting money aside to cushion an unexpected expense is an important financial management tool to keep you from dipping into savings or debt sources when acute financial needs surface.

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Define what is an emergency

Since emergencies are sudden and unexpected, it may be easier to define what they're not, rather than what they are.

Your kid’s senior prom, not having Super Bowl tickets or being behind on your holiday shopping are not emergencies. True emergencies come out of nowhere and can hit you with a major expense, or interfere with your ability to earn money.

Examples include a major car repair, the loss of a job, or a burst appendix that requires big out-of-pocket medical costs. For these situations, you want to set up an emergency fund.

The common arguments for emergency savings

Ready cash for unexpected expenses: Sudden expenses are bound to arise. Having adequate emergency savings can keep these expenses from disrupting your budget. It can also prevent the need to turn to debt, particularly credit cards, to cover short-term, unexpected expenses.

Being prepared for an income disruption: The job market is not as secure as it was just a few years ago. Not only have job losses become fairly normal, but they often occur on short notice. An emergency fund can bridge the gap between when you receive your last paycheck and when your unemployment insurance benefits begin. That will help remove the financial shock the loss of a job can cause.

Avoiding the need to liquidate investments on short notice: If all of your money is tied up in either investments or retirement savings, you may be forced to liquidate positions in order to cover emergencies. This can force you to sell investments at the worst possible time. A well-stocked emergency fund can keep this from happening.

Keeping small problems from becoming big problems: Whether a problem is actually minor or a full-blown crisis is usually determined by the resources you have available to deal with it. For example, let's say your car needs a $1,000 repair. If you have $10,000 in emergency savings, the repair will mostly be an annoyance. But if you have no liquid cash at all, it can turn into a disaster from the start. Emergency savings have a way of keeping problems under control.

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The common arguments against emergency savings

You can always tap a credit line: Since credit has become so widely available in recent decades, there is a belief that unused credit lines can function as emergency savings. This is particularly prevalent since so many people have credit cards with available balances. This enables you to tap emergency cash only when it is needed and without having to have a reserve available for that purpose.

A Roth IRA can work as an emergency fund: Since contributions to a Roth IRA are not tax deductible, you can withdraw them at any time without having to pay regular income tax or an early withdrawal penalty. In this way, the Roth IRA functions as both a retirement plan and emergency savings.

The return on safe, liquid investments is poor: With the decline of interest rates over the past 34 years, the return on safe, liquid interest-bearing accounts has been admittedly poor. Accounts such as savings accounts, money market funds and short-term certificates of deposit (CDs) are well below 1% per year. Since that is a guaranteed money loser when you factor in inflation, the thinking is that emergency savings become a negative investment.

If you're rich enough you don't need emergency savings: The general thinking is that if you have a large enough asset base, emergency savings are unnecessary. The thought is that there is almost always an account somewhere that can be skimmed to cover short-term emergency cash needs.

Why you need an emergency savings fund

Annual household spending in the U.S. is $66,928, on average, according to the U.S. Bureau of Labor Statistics, so a six-month emergency fund for average earners should be approximately $33,464. A three-month fund would be $16,732.

Five-figure savings goals can be intimidating. Just remember that saving even a small amount each month is better than saving nothing at all. Stick to your goal, whether it’s $500, $200 or even $50 per month.

Jump-start your savings by shopping around for a bank that offers an introductory bonus for new customers. And resist the urge to blow the next big tax refund you receive. Each time you get an unexpected windfall, sock it away into the best savings account.

If you build a big enough buffer, you’ll never have to go into debt for unplanned expenses. You'll be able to afford your new transmission or appendix surgery, and you won’t drain your retirement fund or be forced to sell stocks at a loss.

Choosing the right account for an emergency fund

Your emergency fund should be accessible enough that you can withdraw money on short notice, but not so accessible that you can just dip into it on a whim.

Consider opening a high-yield savings account or money market account. Compare interest rates and fees. Make sure it’s convenient for transferring or withdrawing money in a hurry.

Eliminate the need for self-discipline or willpower. If your employer pays by direct deposit, divert a portion of your earnings to the savings account. If you deposit your paychecks into a checking account yourself, set up automatic recurring transfers to the emergency fund account.

You might also choose to put your emergency money into CD, which can pay higher interest than a traditional checking or savings account. But there are pros and cons, because those are designed to be longer-term investments.

Banks and credit unions typically charge penalties for cashing out CDs early. The penalties can encourage you to leave your emergency savings alone, but you'll take a financial hit if and when something happens and you need to tap into your money.

More: Credit unions vs. banks: Which one is right for you?

How much should your emergency fund have?

At a minimum, every household should save enough to cover expenses for three months. The target amount depends on factors such as the number of kids in the home, how much is owed on the mortgage, and each breadwinner's career prospects in the event of job loss.

Some experts recommend that you put aside enough money to get by for six months, while personal finance personality Suze Orman said the coronavirus crisis was so bad that the new standard should be three-year emergency funds.

Once you've decided how many months (or years) your emergency cushion should cover, tally up your regular expenses — including rent or house payments, a car payment, car insurance, child care, utilities and groceries.

When you've determined your monthly expenses, determine your savings goal by multiplying by the number of months you want your fund to cover. A banker, accountant or credit counselor can take a look to make sure you’re on the right track.

Another great idea is to start by using a savings goal calculator to get a roadmap to achieve your financial goals.

More: Suze Orman says Americans need to do this to survive their next crisis

Tips to grow your emergency fund

One surefire way to boost the amount you can save is to stop spending money. Scrutinize your bank and credit accounts to find out where it’s all going.

Consider downgrading or eliminating cable TV. Cancel the gym membership, and work out for free at the community center. Skip the daily Starbucks, carpool to work, install a programmable thermostat and cook at home.

Teach art, music, swimming or carpentry in your spare time. You can also make extra money with any marketable skills you have by freelancing. Sell excess furniture, electronics and housewares on eBay or Craigslist.

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Doug Whiteman Former Editor-in-Chief

Doug Whiteman was formerly the editor-in-chief of MoneyWise. He has been quoted by The Wall Street Journal, USA Today and CNBC.com and has been interviewed on Fox Business, CBS Radio and the syndicated TV show "First Business."

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