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How to Build an Emergency Fund, in 4 Steps

By: David Bach  |  Last Updated: February 23, 2021
Financial Expert & 10x New York Times Bestseller
IN THIS ARTICLE1. Decide how big of a cushion you need to sleep well at night
2. Don’t touch it unless you have an actual emergency
3. Put your emergency money in the right place
4. Automate your savings

Having an emergency fund to fall back on is a crucial component to your financial life — it protects you in bad times and lets you take advantage of opportunities in good times. But it’s especially important to have one now, as the Covid-19 pandemic continues to affect millions of Americans. 

When the going gets tough, you want cash. So if you haven’t already built a cash reserve, or if you’re among the 14% of U.S. adults forced to empty their emergency savings during the health crisis, the time to start saving is now.

I’m here to help you get to where you need to be. Just follow these four steps and you’ll be well on your way to having a fully-stocked emergency fund.

1. Decide how big of a cushion you need to sleep well at night

I always recommend having a cash cushion of at least three months’ worth of expenses. Though, with all the economic unrest these days, I’d aim to have six months’ worth. Depending on your situation, you may even want closer to a full year of expenses saved up. With that much saved, you don’t have to worry about making ends meet even if you lose your job and can’t find a new one for a while. A one-year cushion also gives you the freedom to make decisions about your life that you might not be able to make now, like whether to leave a job you don’t like so you can risk trying a new career.

Ultimately, how much you should save depends on what you feel you need to sleep well at night. Is your job secure? Do you have a family to provide for? Parents to support? Three months’ worth is a great starting place, but if you want to go higher, by all means do what feels right to you.

Once you decide how many months you want to have covered, figure out what that equates to in dollars. If you’re comfortable having a three-month cushion and typically spend $3,000 a month, that means you want to aim to save at least $9,000 ($3,000 times three).

If you owe credit card debt, my advice is a bit different: I recommend building up one months’ worth of expenses in your security account and then concentrating on paying down your debt. Why? Because it doesn’t make sense to have money earning say 0.5% in a high-yield savings account at the same time that you’re paying 20% on your credit card debt. Once you’ve eliminated your debt, you can then go back and beef up your emergency fund.

2. Don’t touch it unless you have an actual emergency

The reason so many people don’t have any emergency money is because they have what they think is an emergency every month. That new pair of shoes you’ve been eying, or that set of golf clubs or mini vacation you “need” are not emergencies! 

You know what a real emergency is. It’s something that threatens your survival, not just your desire to be comfortable. Don’t touch your rainy day fund unless you’re facing a real emergency. 

It’ll be easier to follow this rule if you keep your emergency money separate from your checking account. When your spending money and emergency money are in the same place, it’s too easy to dip into the emergency money to cover monthly expenses. Plus, if it’s sitting in your checking or savings account, it’s probably earning virtually zero interest. 

3. Put your emergency money in the right place

Now that you’ve decided you’re going to separate your emergency fund from the rest of your money, where do you keep it? There are no easy answers right now. Interest rates have plummeted amid the pandemic and you’re not going to find some hidden account option offering double-digit returns. In fact, I would be wary of options that seem really attractive — they might come with baggage, like expiring teaser rates, access delays or withdrawal penalties.

Finding a great place to keep your emergency money is harder than ever, but here are two of your best options:

High-yield savings accounts

While “high” is a relative term these days, you can still find some savings accounts out there with appetizing yields, especially compared to the national average interest rate on savings accounts (0.05% as of February 2021, according to the FDIC). Many of these are from online banks, which are just as legitimate (and FDIC-insured) as their brick-and-mortar counterparts.

There’s Synchrony, which is currently offering a rate of 0.5%.* And Marcus by Goldman Sachs (the consumer arm of the storied investment bank), which is also offering 0.5% APY. That’s 10 times the national average.

The advantage of a straight savings account is that you’re not locking up your money in a place that’s difficult to access – after all, the point of having an emergency account is to have accessible cash. Plus, these accounts are FDIC-insured, so you can be sure your money won’t vanish even in the event of economic catastrophe.

Certificate of Deposit accounts (CDs)

While standard savings accounts let you put money in and take it out at will, CDs work a little differently: You deposit a fixed sum for a fixed term and then enjoy relatively high interest rates.

Before the pandemic, rates on CDs were close to 2% or more. Now, they’re lower: Marcus by Goldman Sachs is offering 0.55% APY on 12-month CDs and Discover is offering 0.5% for the same term.

The potential danger of this strategy is that most CDs charge penalties for early withdrawal. So, if you need that money before the term is up, you’ll owe a fee. (Some offer no-penalty versions with lower interest rates). If the purpose of your cash fund is to have immediate, unfettered access for emergencies, then this type of account may not be the right fit for you.

One creative idea is to stagger your CDs. That way you have some cash at the ready, while another portion is locked up and generating higher returns for you. This is also known as a CD ladder.

A mixed approach

You don’t have to choose just one avenue for your cash. Financial planner Joseph Stemmle of Richmond, VA recommends a mixture of multiple options: “Building a three-tiered cash reserve is essential to getting your money to work harder,” he says.

“Tier 1 is one month of expenses in a checking or savings account at your primary bank, Tier 2 is one to three months of expenses in a high-yield savings account that is FDIC-insured with no minimums and Tier 3 is three to six months of expenses in a CD, Treasuries or short-term bonds.”

Whichever route you choose for your savings, just remember that your first principle should be: Safety first. If you reach for an artificially high yield, but end up locking it up for an extended period or putting the sum at high risk, then you are defeating the purpose of having emergency savings in the first place. If and when you find yourself in a real financial crisis, that’s not a happy place to be.

*Note that APYs listed are current as of the time of publication and may fluctuate.

4. Automate your savings

Once you’ve decided what account you want to use, start funding it automatically. To do this, first check to see if your employer will directly deposit a portion of your paycheck into your emergency account. Contact your benefits office and ask if the company offers payroll direct deposit. If they will, you can arrange to have part of your paycheck automatically deposited wherever you want. All your employer needs is your account number.

If your employer won’t do direct deposit, arrange to have your checking account automatically fund your emergency fund every two weeks (or however frequently your paycheck lands). You should be able to set this up online. If you can’t find the option on your bank’s website, call them.

As for how much to save each month, I suggest contributing at least 5% of your net take-home pay. Calculate what dollar amount that equates to, have that amount automatically transferred to your emergency fund every time you get paid and keep contributing to that account until you’ve reached the number you decided on in step one.

Read next: 7 Places Your Money Needs To Go Automatically if You Want to Build Wealth