This is a guest post written for playlouder.com by Aileen Colon. Please note that guest post opinions are of their author. They are not always in strict alignment with my own opinions. – Joe
We’ve all read the news: The amount of student loans the nation has accumulated is staggering. As of last year, the Federal Reserve System reported that college debt reached $1.6 trillion, with 65% of graduates earning their degrees with an average debt of $29,000.
These days, being burdened by debt is almost a guarantee for college graduates before even earning their first paycheck. So why should building an emergency fund become a top priority? In a way, it makes financial sense to pay off student loans as soon as you land a job. Right?
Well, that’s not entirely correct. Paying debt is a financial goal that should go hand-in-hand with saving money, which can be in the form of setting up an emergency fund or making investments. Credit expert LaToya Irby points out the obvious downside of skipping savings in Should You Save Money or Pay Off Debt?: having no safety net in an emergency.
On the other hand, ignoring your debt in order to focus on saving is a bad idea, too. It can mean having to pay off debt and its compounding interest way into retirement. The best approach, then, is to find a balance between debt repayment and savings, which include funds set aside for emergencies.
What is an emergency fund and why do I need it?
Simply put, an emergency fund is money stashed away for emergencies. Think of it as a safeguard for when something unexpected happens, saving you from having to take out another loan or racking up on credit card bills.
Of course, what qualifies as an emergency varies from person to person. Generally, this is a situation requiring you to pay or adjust to a sudden expense or lack of income. Emergencies are sometimes quite literally a matter of life or death, or are relevant to your overall health and financial wellbeing.
Some examples are losing your job or incurring a sudden medical expense. Unexpected home, car, and even appliance repairs are also considered emergencies.
However, expenses like last-minute vacations, shopping sprees, and new gadgets shouldn’t qualify. Even utility bills don’t count, as they should already be part of your monthly budget.
As for millennials, a fascinating discussion on ‘The Predictable Effects of Unpredictable Financial Emergencies' by The Atlantic warns that sustaining financial hardship is an all-too-common effect of going through an initial financial shock.
Emergencies may be hard to recover from, especially for those who are still in entry-level jobs — making it all the more important to set up an emergency fund.
How much should I put into my emergency fund?
The size of your emergency fund is a personal matter, but there are some general rules you can follow. CNBC’s expert guide on emergency funds recommends starting with an aim of saving $2,467 for low-income households.
This figure is based on economists’ research on minimum savings that prevent low-income households — who make up around 30% of the U.S. working-age population — from falling into long-term financial hardship. Given that you’re still in the process of establishing a career, this number should serve as a helpful benchmark.
Then, you can continue adding to this amount until you eventually have a sizable emergency fund. Other experts recommend saving at least three to six months’ worth of income, a figure that could be your long-term goal. In the meantime, a smaller sum, like the suggested $2,467, is more realistic and achievable.
Hitting this initial target can give you feelings of accomplishment that will help you build momentum in your long-term financial goals.
Where do I put my emergency fund?
Due to its nature, an emergency fund should be liquid, but that doesn’t mean you should be hiding money in a piggy bank. It’s best to separate it from your checking or main savings account. Two popular options for doing so are high-yield savings accounts and money market accounts.
A high-yield savings account is a type of savings account that earns you a higher interest than traditional ones. The annual percentage yield (APY) is a good way to judge how much a bank will pay you in interest, as it accounts for how many times your interest compounds in a year.
The more often the interest is compounded, the higher your interest becomes on your emergency fund. In their article about high-yield savings accounts, Marcus points out that for a $5,000 balance, the interest can compound to $127.50 at 2.55% APY. That said, always be sure to study the fine print when choosing the type of high-yield savings account to store and grow your emergency fund.
On the other hand, a money market account essentially places your funds in a bank or credit union to earn interest. The Street’s pros and cons list for money market accounts highlights that these accounts offer different withdrawal options, but they usually come at a limit.
But similar to high-yield savings accounts, money market accounts also offer higher interest rates than traditional bank accounts, giving you the potential to keep growing your emergency fund while you don't need it.
Once you’ve figured out the right balance between debt repayment and savings, the next step is to look at investment opportunities. To help you get started, check out our post on “Big Picture Investing: Why You Need to Get in the Game Now!“
Emergency Fund: How Much is Enough?
How to Make Your Money Work for You: 7 Modern Methods for Investing in “The Market”
The Financial Planning Process: How to Mastermind Your Retirement
Early Financial Independence: Living Your Life in 4 Acts (Not Just the 3 You’ve Been Told About)!
How Our (Semi-ish) Early Retirement Aspirations Grew from a Spark to a FI/RE