It's always shrewd to save for a rainy day. But when a sunny economy threatens to turn stormy, it becomes even more critical to build a cushion of savings that can soften the blow of a potential financial emergency. Here's what you need to know about saving in an emergency fund during an uncertain and changing economy.
Why You Need an Emergency Fund
We never know what unwelcome financial surprises may be around the corner, such as a sudden unexpected expense, job loss or decrease in income. Instead of taking on debt or dipping into your retirement savings, you can rely on an emergency fund for a source of readily available cash to cover such financial shocks. This not only gives you peace of mind in the present, but also allows you to avoid extra debt-carrying costs or early withdrawal penalties that can affect your finances long into the future.
What an Emergency Fund Can Be Used For
The cash reserves you keep in an emergency fund can generally be used in two ways:
1. To pay for unplanned (but necessary) expenses. These are out-of-the-ordinary costs that you could not have anticipated, such as uninsured medical bills, urgent home/car repairs or other emergencies.
2. When have a decrease or interruption in income. If your hours are cut back, you're laid off or you cannot work due to illness, you can use your emergency fund to pay for your monthly needs, including rent/mortgage, food, utilities, etc.
Emergency funds should not be used for discretionary expenses, such as entertainment, travel, shopping, eating out or any other “wants" (as opposed to needs)—regardless of your employment or income status.
How Much to Save in an Emergency Fund
Experts generally recommend saving enough cash in an emergency fund to cover three to six months' worth of living expenses. Of course, that estimate makes a few assumptions. First, it anticipates that your expenses will remain static over time. In other words, it assumes that your various monthly costs won't increase before you need to tap into the cash in your emergency fund.
Second, it assumes that if you're laid off, you'll find another job with a comparable income within that six-month time frame.
But depending on the state of the economy, those assumptions may not hold true—which means you may need to adjust the ideal balance in your emergency savings, as explained below.
Economic Conditions That Impact Emergency Savings
There are several economic factors to consider when planning how much to save in an emergency fund, including the following:
Inflation
When prices increase rapidly during periods of high inflation, you lose purchasing power on your savings. So, while you may have carefully budgeted six months' worth of expenses to hold in your emergency fund, that cash might only cover five months of costs by the time you need to use those savings. That's why it's important to revisit your budget on a regular basis to see how much you're actually paying for all your needs, and then increase your emergency fund to cover those higher amounts.
Interest rates
If you have any debt with a floating rate of interest—such as a variable-rate mortgage or line of credit—your debt-carrying costs go up when interest rates increase. Even if you have a fixed-rate mortgage or loan, you're looking at an increase in your debt payments upon renewal if interest rates rise. You don't want to be caught short—and potentially default on your loans—if you lose your income, so it's wise to add a premium to your emergency savings when interest rates are on the rise.
Labor market
Try to stay up-to-date with the job market in your field so you have a good idea how long it might take to find a comparable position if you're laid off. If there have already been cutbacks in your industry, prepare for a possible layoff by boosting the savings in your emergency fund to cover a year's worth of living expenses in case it takes you that long to find work.
General economy
A strong economy means businesses are doing well and are more likely to retain staff and offer raises to their employees. In a weak economy, however, businesses tend to cut back by imposing wage freezes or layoffs. Even if you haven't seen layoffs in your field yet, a looming recession is enough of a risk to pad your emergency fund, just in case.
How to Prepare for a Financial Emergency
Although it may be a challenge to set aside additional emergency savings when your budget is already squeezed by inflation and rising interest rates, it's not impossible. Here are some tips to get you started:
- • Pay down higher interest debt. Unpaid credit card balances and high-interest loans cost you a bundle in interest charges. Reducing your debt will not only lower your monthly expenses, but also create more money in your budget for savings.
- • Switch to an emergency budget. This type of budget is like a no-spend challenge—which basically eliminates all discretionary spending for a limited period of time—and can be an effective way to quickly beef up savings.
- • Earn more on your savings. The right savings products, such as a high yield savings account or CD ladder, can maximize your interest income while still offering easy access to your cash in case of emergency.
- • Refocus your efforts. If you contribute monthly to retirement savings, consider redirecting some of those contributions to your emergency fund—at least until you've accumulated enough cash savings to feel secure. Do the same with your tax refund or any other occasional income.
Vivid Crest Bank for Emergency Funds: Start Saving Now!
Every dollar you sock away today is one less dollar you'd need to borrow tomorrow if there's an emergency. And with a Vivid Crest Bank high yield savings account helping your savings grow, you'll be better prepared to handle whatever financial surprises come your way.
Tamar Satov is a freelance journalist based in Toronto, Canada. Her work has appeared in the Globe and Mail, Today's Parent, BNN Bloomberg, MoneySense, Canadian Living and others.
READ MORE: Personal Finance 101: Emergency Funds