Sep 16, 2020
28% of Americans Have No Emergency Savings — How to Get Your Rainy Day Fund in Place
Are you part of the 28% of Americans that have no emergency savings? If so, it may be time to build a rainy day fund so you don’t have to turn to credit cards, personal loans, or asking family for financial help.
What is a rainy day fund?
“When it rains, it pours”, as they say. A rainy day fund is a fixed amount of money set aside to help cover expenses in case of an emergency. This is separate from any retirement funds or investments (though there are rare and extreme cases where you may tap into these as additional emergency support).
How do I get there?
Building a rainy day fund can seem daunting, especially when you have other financial stressors, such as credit card and student loan debt.
To start, calculate your total monthly necessary expenses. This should include your rent/mortgage, utilities, groceries, and transportation. What is left?
If nothing, then you need to find ways to reduce your monthly expenses or generate additional cash flow.
Tip 1: To reduce your grocery bill, build a list, stick to it, and cook in bulk.
Tip 2: To generate additional cash flow, consider easy passive solutions, such as car decal advertising. Yes, you can make several hundred dollars a month using your car as a billboard.
If you have surplus (money for eating out, vacations, shopping etc.), you should save 100% of that excess until you reach your rainy day fund goal. If you are concerned about your self control, set up an automatic payment into a separate savings account.
How much money do I need to save?
Advice varies on how much money should be in a rainy day fund, but for starters, you need to have a floor of $1,000. That way, you are protected against going further into debt from a surprise expense while you are building the remainder of your rainy day fund.
Ultimately, you should target savings of 3–6 months of expenses. How you get there depends on which school of thought you choose to follow.
During the COVID-19 pandemic, some financial experts recommend increasing your rainy day fund to 9–12 months of expenses, given mass unemployment and economic instability.
School 1: Pay Off Debt Before Completing Your Rainy Day Fund
One philosophy is to pay off all of your debt (except your mortgage) as quickly as possible after you accumulate $1,000. That way, should you have a change in situation, you will not be burdened by monthly payments and interest. Then, once you pay off all debt, you go back to saving in your rainy day fund until you reach 3–6 months of expenses.
Pro: You lower the risk of interest snowballing and pay off your debt sooner.
Con: You have less financial protection against sudden life changes.
School 2: Complete Your Rainy Day Fund Before Paying Off Debt
Conversely, others recommend building 3–6 months of expenses up front while making the minimum monthly payments on your debt. This philosophy figures it doesn’t matter if your student loans are paid off if your car breaks down and you can’t afford the repairs. Once your full rainy day fund is built, you go back to tackling your debt aggressively.
Pro: You are able to weather a greater number of unexpected financial burdens that may fall at the same time.
Con: You are exposed to the risk of interest accumulation against outstanding debt.
Where should I store my rainy day funds?
An important feature of your rainy day fund is accessibility. You need to be able to access the funds quickly and without penalty in the case of an emergency.
“Choose an account that keeps the money safe from loss, meaning the value won’t fall due to declines in the financial markets, and liquid, meaning you can access your money at any time with no fee or restrictions.” — Ric Edelman
There are several options:
Checking Accounts
A checking account is your standard, everyday deposit account at your bank.
Pro: Accessible through your debit card and ATM machines.
Con: Low interest (often less than 0.1%).
High-Yield Savings Accounts
A high-yield savings account functions like a regular savings account, but you can earn more interest (0.6% Annual Percentage Yield (APY) vs. 0.9% APY).
Tip: When picking a bank to host your high-yield savings account, make sure it is a Federal Deposit Insurance Corporation (FDIC)-insured bank.
Pro: Higher interest rates than checking accounts.
Con: Potentially higher fees and a possible delay in receiving your funds, since you are unable to go to a brick-and-mortar bank. Also, the interest yield still doesn’t beat annual inflation (2–3%).
Certificates of Deposit (CD)
A CD is a savings account with a fixed interest rate that is usually higher than a traditional savings account, but also has a required term length.
Pro: Potentially higher interest than traditional bank accounts.
Con: You have to leave your funds in the account for a specified amount of time (ranging months to years). If you remove the funds prior to that date, you face penalties. You can consider CD ladders to work around this, but that is not the focus of this article.
Money Market Accounts
A money market account is a deposit account similar to your checking account, but with potentially higher interest yield.
Pro: Offers debit cards or check-writing for more convenience.
Con: Possible minimum balance requirements and monthly withdrawal/transfer limits.
Money Market Funds
A money market fund is a low-risk mutual fund rather than a type of account.
Pro: Highest potential gain to protect your savings against inflation.
Con: Greatest risk because this is an investment, not an actual account. Also, this means it is sponsored by an investment company, not insured by the FDIC.
Does this mean I shouldn’t save for retirement while building a rainy day fund?
Saving for retirement is extremely important. We are living longer and Social Security funds are heavily depleted, currently projected to run out by 2035. So is it smart to stop saving for retirement while you are trying to build your emergency savings?
Some financial institutions recommend saving for retirement while you are building your rainy day fund. It should be noted that these institutions are the ones managing the retirement investment portfolios, so of course they want you to keep putting money in. But, if you have an emergency and have to dip into your retirement, you face a 10% tax penalty, which further derails you from reaching your goal.
Personal financial advisors, however, often say it is appropriate to pause your retirement contributions while you build your rainy day fund. You shouldn’t invest anywhere if you don’t have emergency savings in place. However, be sure to contribute to your retirement account as soon as you meet your goal.
What if I need to use my rainy day fund?
If you need to use your rainy day fund while you are building it, that’s okay. That’s what it is there for. Just be sure to replenish the funds you use so you don’t end up in a deficit for future emergencies.
Everyone should have a rainy day fund in place. It is a crucial first step to building a healthy financial household. When deciding what approach is best for you, consider your personal situation. Is your job secure or at risk? Are you a single household or do you have dependents? Do you have a severe health condition? Your personal risk levels will dictate what works best. And you may choose to move between the two philosophies as your situation changes. It doesn’t matter how you get there, just so long as you are committed and diligent along the way.
Have questions? Send them to unsexytoolkit@gmail.com and I’ll address them in future articles.
This article is for informational purposes only. It should not be considered Financial or Legal Advice. Not all information will be accurate. Consult a financial professional before making any major financial decisions.
