Emergency funds and savings accounts are two key pieces of your financial picture. Broadly speaking, one helps you prepare for emergencies, while the other assists with setting aside money for various goals and earning interest.
However, there are more differences to discuss. Knowing how each of these works helps you determine how best to use them to work toward your financial goals. This article will explain how emergency funds work and how to build an emergency fund. Then, we'll discuss how savings accounts work and compare them to emergency funds.
How do emergency funds work?
An emergency fund is a savings fund you set aside for emergencies, such as car crashes, job losses, unexpected medical bills, or emergency travel. This fund provides you with money both to cover the emergency-related expenses and your general living costs if the emergency takes you away from work. At the same time, it helps you avoid debt.
For example, if you lose your job, the emergency fund helps you cover basic living expenses as you look for a new one. Another example might be a car crash. This might leave you temporarily unable to get to work and may involve repair or medical costs. The emergency fund pays for these costs alongside regular living expenses.
Many experts recommend saving three to six months of living expenses in an emergency fund. Some people may aim for the upper end or save even more if they have larger families.
How to build an emergency fund
To build an emergency fund, open a high-yield savings account and decide on a fixed percentage you want to save each month. Then, you can update your direct deposit at work to send that percentage of your paycheck to the account until you've reached your savings goal.
Alternatively, you can deposit all to your checking account and set up automated recurring transfers to your high-yield account. Once you've reached your goal, turn off these transfers or update your direct deposit again.
How do savings accounts work?
Savings accounts are bank accounts that let consumers deposit their money. Many savings account earn interest, and limit withdrawals to six per month to incentivize saving. Going beyond this limit may incur fees or cause your withdrawal to be denied. In general, savings accounts are FDIC-insured up to $250,000. That means if the bank goes under, the government will recover up to $250,000 of your money for you.
Differences between an emergency fund and a savings account
Here are some key differences between emergency funds and savings accounts:
Goal vs. account type
An emergency fund is a sum of money to help you in certain unfortunate situations. It's a financial goal to aim for. However, a savings account is merely a type of bank account. You can put any amount of money into a savings account.
Emergency funds are supposed to be used only for emergencies, like medical expenses or job losses. You shouldn't dip into them for discretionary purchases or even living expenses if you have a paycheck and no emergencies to handle.
Savings accounts can be used to save for anything. You might use the funds in your savings account for an emergency fund, a travel budget, or a large purchase.
Savings accounts nearly always pay interest. Traditional accounts have low rates. However, high-yield savings accounts may pay much more. Emergency funds, on the other hand, don't inherently earn interest. They must be in an interest-bearing checking account or a savings account to earn it. It's recommended to save them in a high-yield account to maximize earnings on the money while it sits dormant.
The bottom line
Emergency funds help you prepare to pay for emergencies and cover living expenses during those emergencies while minimizing debt. Savings accounts are bank products designed to help you earn interest on your savings and work toward financial goals.
These two aren't mutually exclusive. You can use a savings account to stash your emergency fund. That way, your emergency fund earns interest and keeps up with inflation while not in use. Then, when an emergency strikes, you'll be prepared to take it on.
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