One of the most important parts of being financially secure is having an emergency fund. You never know when you’ll have an unplanned expense, but everybody deals with them at some point. By having money set aside in a savings account for these situations, you won’t need to go into debt.
Since your emergency savings is so crucial, you don’t want to make any costly mistakes with it. Here are five of the most dangerous.
1. Not saving enough
The most common recommendation on emergency funds is to save three to six months of living expenses. If your living expenses are $3,000 per month, then your goal would be $9,000 to $18,000.
It’s a lot of money to save, and it takes time to get there. But if you don’t have at least three months of expenses in your emergency fund, keep saving money toward it every month. Emergency expenses can be costly, and you don’t want to come up short.
Your emergency fund is also your protection against a loss of income. If you lose your job, having three to six months of savings gives you time to get back on your feet. If you know your savings will run out in a month, it puts you in a much more stressful situation.
2. Investing it in the stock market
Instead of using a savings account, some people decide to invest their emergency savings. Over long periods, the market tends to outperform bank accounts by a wide margin. The S&P 500 (one of the major stock market indexes) has an average annual return of about 10% per year.
The problem is that the stock market is volatile. Historically, it has delivered excellent long-term performance. But it fluctuates from year to year. For example, in 2022, the S&P 500 declined by nearly 20%.
Imagine you invest $10,000, and then its value declines to $8,000. If that’s retirement savings you don’t need for decades, you have plenty of time to wait for the market to rebound. If that’s your emergency savings, you may need it at any time. You could be forced to sell your investments at a loss.
3. Using it for non-emergency expenses
When you have a large amount of money saved, it’s tempting to dip into it. Remember that an emergency fund is for emergencies only. You shouldn’t use it for a vacation, holiday gifts, a down payment on a home, or any other non-emergency expenses.
Those are all expenses you can and should plan for ahead of time. Estimate how much money you’ll need, and then save for it every month. If you use your emergency savings instead, you could be left unprepared when a real emergency strikes.
4. Not rebuilding it after you use it
After you’re withdrawn from your emergency savings, you need to save and get it back to where it was. Depending on the situation, you might not be able to do this right away. If you lost your job, you’ll need to wait until you’re back on your feet and earning money again to rebuild your emergency savings.
This is a normal cycle people go through. You use some of your emergency fund. As soon as you can, you figure out an amount you can afford to save toward it every month, and you start rebuilding.
5. Overfunding it and neglecting your investments
Not saving enough is a more common mistake, but it’s also possible to overdo it with your emergency fund. Some people put most of their extra money in emergency savings and neglect their investment accounts.
If you want to save extra cash for emergencies, there’s nothing wrong with that. But few people need more than a 12-month emergency fund. If you have more than that in yours, consider moving a portion to your investment portfolio. Your money could grow more this way, and you’ll still have plenty saved for emergencies.
Emergency fund mistakes can cost you money and cause unnecessary financial stress. Now that you know what to avoid, you can avoid doing anything dangerous with your own emergency savings.