In life, as the saying goes, you can expect the unexpected. You never know what’s just around the corner. Tomorrow you might run across the opportunity to invest in a once-in-a-lifetime venture, or maybe your car will break down.
Having a sturdy financial foundation will prepare you for both the good and the bad. However, most Americans are not ready for a slight rain, much less a hurricane-level financial catastrophe. In one recent survey, 21% of Americans reported saving nothing at all, while another 20% reported saving 5% or less. In fact, the average American savings rate has been trending downward since the late 1950s, standing at a 7.5% savings rate in January 2019. The result: 60% of Americans couldn’t cover a $1,000 major unexpected expense without going into debt.
This doesn’t have to be the case. Saving should be a part of any healthy financial strategy, and there are two key funds that every individual should have to avoid a financial catastrophe: an emergency fund and a rainy day fund. The difference between these two types of savings may be subtle, but here we’ll explain why you need them, what they are, and how to set them up. So rest assured, you’ll be able to survive any storm — whether it’s a tiny shower or a tsunami.
First of all, it’s important to understand why you should save. According to a 2017 CareerBuilder survey, 78% of Americans live paycheck to paycheck. That means that every little bump in the road could potentially derail an entire household’s financial health. Anything from an unexpected parking ticket to a more serious car accident — without a savings cushion — could set off a spiral into debt that might take years to escape.
If you don’t have even a small amount saved, you might have to take out a high interest personal loan from your bank or use credit cards to cover the gap. According to the Federal Reserve, the average interest rate on a 24-month personal loan in Q4 of 2018 was 10.65%, while the average interest rate on a personal credit card was even higher at 16.86% for the same period.
What Does This Really Cost You?
Let’s say you had to borrow $1,000 to cover a sudden expense. If you were to take out a two-year consumer loan at 10.65% to pay your debt, you would be stuck with a monthly payment of $46.45 every month for 24 months, and would end up paying $115 in interest.
On the other hand, let’s say you were to pay your sudden $1,000 expense with a credit card at a 16.86% interest rate. If you were to pay off your credit card in the same two-year time frame, you would be saddled with a $50 monthly payment for 24 months, and end up paying $190 in interest.
While those monthly payments might not seem like much on paper, keep in mind that if you find yourself in the situation where you needed to cover expenses with high interest financing options, an extra $50 a month could handicap your financial health even more — stretching your already limited resources.
What Are Other Considerations?
Additionally, if you fail to make those monthly payments or default on other debts, it could negatively impact your credit rating. This, in turn, would mean that if you had to take out more loans in the future to cover other unexpected expenses, the interest rates on those loans would likely be even higher than the national average — meaning it would be even more difficult for you to get out of the debt you already have.
As you can see, without the ability to pay for emergencies up front, you can easily enter into a cycle of debt that becomes almost impossible to escape. The only way to get out of this downward spiral, or avoid it altogether, is to save.
Emergency Fund vs. Rainy Day Fund
While most people know, at least in theory, that they should save some of their income, as we’ve seen, they don’t. If they save anything, many only put a bit of money sporadically into a savings account. Or perhaps they divert some savings into a 401(k) or IRA retirement account. While it’s a good start to save because you generally know it’s a good idea, saving with a purpose can put your financial trajectory into hyperdrive.
To get started, there are two particular savings funds that financial experts recommend:
- An emergency fund
- A rainy day fund
While the variations between these two types of savings funds may be subtle, it’s important to know the difference.
An emergency fund is a savings fund intended to cover your financial obligations in the case of a serious life emergency. For example, perhaps you experience an unexpected job loss and still need to be able to make rent. Or you or a loved one might have a serious health issue that requires a hefty outlay of cash. In both of these cases, you would use an emergency fund to get through the rough patch.
In general, financial planning experts recommend having anywhere between three and six months of living expenses set aside — although we would strongly encourage putting away between eight and 12 months. As an example, suppose your basic monthly expenses total $3,000 — this would include rent or mortgage payments, car payments, insurance, groceries, and any other mandatory monthly payments. Following the conventional wisdom, you would need to have a minimum balance in your emergency fund of between $9,000 and $18,000.
Rainy Day Fund
In contrast to an emergency fund, which is intended to cover the barest monthly expenses you would need to pay in case of a catastrophe, a rainy day fund is intended for short-term emergencies on a smaller scale. For instance, you would use a rainy day fund to cover the costs of an unexpected car repair, a leaky roof, or a one-time medical bill. For most, having a rainy day fund of around $1,000 is a good start toward covering most unexpected expenses.
How to Save
It’s all well and good to say you should have an emergency and a rainy day fund, but how are you supposed to find the money to reach these savings goals?
First, you should determine how much you need to have saved. This number will vary depending on your income and expenses. If you can only manage to set aside three months of expenses in an emergency fund — let’s say that’s $9,000 as an example — and $500 in your rainy day fund, that’s fine. It’s important to start somewhere.
Next, once you’ve decided on your savings goals — in this case, a combined $9,500 — determine how much you can reasonably put aside each month. When you’re getting started, it might be helpful to create a budget using the 50/30/20 method. With this tactic, 50% of your income should go towards necessities, 30% toward discretionary expenses, and 20% toward savings.
Let’s say for the sake of this example that you net $4,000 each month after taxes. Using the 50/30/20 rule, you should be putting aside $800 each month toward your savings goals. If you divide your savings goal of $9,500 by saving $800 each month, you can reach your goal in about a year.
If you want to supercharge your progress toward your savings goals, you can decrease your necessary expenses — your rent, for example — or divert some funds from the discretionary spending bucket to your savings bucket. After all, there are plenty of creative ways you can save money fast.
Where to Save
Now that you know how much money you should save and how to go about creating a savings strategy, you’ll need to put that money somewhere. While there are a few options available, including money market accounts and certificates of deposit, we highly recommend a high interest savings account. There are a number of banks that offer the option to open high interest savings accounts with no monthly fees, with most paying interest on your savings that ranges from 2.00% to 2.45%.
In addition to the fact that your money will make money in a high interest savings account, there are two other reasons this type of bank account makes the most sense: security and liquidity.
The entire point of having an emergency fund and a rainy day fund is to have that money available at all times. That means you want it stored somewhere safe where you won’t lose any of your cash due to ups and downs in the economy. Unlike a money market account, savings accounts are ideal in this respect, as they’re FDIC insured. In other words, the federal government will reimburse your balance up to $250,000 even if the bank in question were to go out of business or default on its debts. For the purposes of your savings goals, your money is 100% safe.
The next important characteristic of a high interest savings account is its liquidity. Unlike a certificate of deposit (CD), which requires you to lock away your money with the financial institution holding the account for a specific amount of time, high interest savings accounts allow for immediate access to your cash. This is especially important when it comes to emergency and rainy day funds. After all, these savings funds are intended to help in case of a financial catastrophe, which means you might need access to your money at a moment’s notice.
Save to Weather the Storm, and to Enjoy the Sunshine
While saving for an emergency or a rainy day is difficult for many, it’s absolutely crucial if you want to build a secure financial future. These savings funds provide a safety net in times of trouble and build up the habit of saving to help you reach other financial goals.
Perhaps you’d like to buy a house or a car at some point in the future, or maybe you want to save for retirement. Once you have your savings accounts fully funded, you can start putting aside the money you would’ve used for your emergency or rainy day funds toward other goals. Saving now can help you avoid potential financial storms, and it can also put you on a course toward more temperate climates where you’ll have blue skies year-round.