What would you do if you encountered an emergency that cost $1,000, such as a car repair or a health issue? If you’re like 61 percent of Americans, you don’t have enough savings set aside to handle a situation like this. Yet 34 percent of American households experienced a major, unexpected expense at some point during the past year.
So how are people paying for those unexpected expenses? Paying the costs from savings remains the most popular method, but 19 percent of people finance those expenses with a credit card, 12 percent borrow from friends or family members, and 5 percent take out a short-term loan.
None of these options is strictly bad, and unexpected expenses are largely unpreventable, but these data indicate a major problem in our collective financial health—and it’s important to guard yourself against their negative effects.
The Threat of Interest Rates
Taking out a short-term loan isn’t a problem if you’re able to pay it off in short order. The problem is, most people take out a loan or charge a credit card without a plan on how to pay it off as quickly as possible. If you let your debt sit unresolved for too long, the power of compound interest will start to affect you negatively.
Take this scenario as an example. The average credit card interest rate is 16.71 percent. If you have $1,000 of credit card debt, you’ll pay an extra $167.10 the first year you don’t pay down that principal (or more, depending on how often it’s compounded). After five years, you’ll owe $2,165. After 10, you’ll owe more than $4,600.
A single charge is unlikely to leave you vulnerable to this exponential negative growth, but if you let too many expenses accrue, or if you fail to take care of your debt in a timely manner, you could eventually find yourself in over your head—and unable to save for more important things, like housing or retirement.
The Threat of Subsequent Emergencies
You also need to think about the threat of subsequent emergencies. If you assume you’ll face a $1,000 emergency every year, and you don’t have enough money to pay for an emergency this year, what’s to stop you from adding another $1,000 to your debt next year? And the year after that? And the year after that? As your debt accumulates, you’ll be responsible for bigger and more menacing monthly payments, which can make it even more difficult to pay off those emergency expenses.
The end result is a vicious cycle that’s nearly impossible to break out of. And many Americans don’t think about the effects this could have on their long-term wellbeing.
How to Create an Emergency Fund From Scratch
The solution is to create an emergency fund from scratch. If you have extra income every month, it shouldn’t be hard to build up to a few thousand dollars in extra savings—but people in this situation probably don’t have a problem with emergency expenses in the first place.
Instead, you’ll probably need to rely on the following strategies to build up your emergency fund:
- Calculate how much you need. There are varying opinions on how much emergency savings you should have, but you’ll need to calculate a rough figure for yourself before you do anything else (so you have a target to work with). Some suggest having up to six months’ worth of expenses saved up, but there are also risks to having an emergency fund that’s too large.
- Cut unnecessary expenses. Next, cut out unnecessary expenses, like subscriptions for services you no longer use. You’d be amazed how quickly these expenses can add up.
- Live below your means. Reduce your spending on things like groceries and entertainment options. Finding coupons, comparison shopping, and living more frugally can add up to save you at least $100 a month in many cases.
- Reduce your housing expenses. If you’re struggling to make cuts, consider downsizing your housing. Housing expenses are one of your biggest line items, so moving to a smaller place or a different neighborhood can save you hundreds of dollars a month.
- Make savings a budget item. Set a goal for saving, whether it’s $1,000 a month or $50. Treat this like a necessary line item in your budget, and you’ll contribute that amount consistently. Eventually, you’ll be able to hit your long-term goal for emergency savings.
- Increase your income. If you’re struggling to hit that goal every month, consider taking steps to increase your income, such as picking up a secondary job, or starting a side gig.
Having an emergency fund is one of the most important steps you can take to ensure your long-term financial wellbeing, since it will allow you to cover inevitable expenses without falling too far into debt or dealing with the repercussions of compound interest. Even if you aren’t making much money, or if you’ve never had an emergency fund before, it’s possible to build one with the right approach.