Nearly 25% of Americans do not have emergency funds. And if you ask if they can cover a $400 unexpected expenses, 59% of Americans said they could not, they have to either borrow from someone or sell something.

However, there is a magic card to help people cover emergency expenses — credit cards. Credit cards do help you to cover unexpected expenses, but the interest rate is ridiculously high, ranging from 17.3% and above.

To give you an idea of how significant this rate is, let’s say you don’t have an emergency fund and used a credit card to pay for $1000.

After 1 year it becomes: $1173

2 years: $1375

5 years: $2220.7

In less than 5 years your debt has doubled. On the other hand, if you want to have an investment that has more than 17.3% annual return, you have to bear a much bigger risk and not sure if it gives you such a return on annual basis. Because the market fluctuates, and you might invest in a bad year.

Therefore, before you start any investing activities, asking yourself:

Do you have an emergency fund?

What is an emergency fund?

As a rule of thumb, an emergency fund can cover your three to six months’ living expenses. If you lose your job, you can still live your life while looking for another one. If you had an accident, you can pay for your medical expenses. If you need to pay for a course which will help you level up your skills, you have the opportunity to take part. There are a lot of unforeseeable situations in life, don’t live on the edge, have an emergency fund, and prepare yourself for the rainy days.

Some people even save up one or two year’s living expenses as their emergency fund. I personally think it is better to have a bigger emergency fund, but it also comes at a cost — opportunity cost. I will talk about it later.

Where should keep your emergency fund?

To be clear, this money is for emergencies. Impulsive shopping is not an emergency, going on vacations is not an emergency, buying a new car is not an emergency. So you have to keep your fund in a savings account which you can not easily get access to. Better there is not direct card link to it so you can not even spend it without physically withdrawing it from the bank. You should make it as less visible as possible and never treat it as disposable cash, treat it as forgotten money. So that you will not find yourself in the situation to spend it. We are humans, driven by emotions, desires, and impulses. Don’t try to test your own willpower. Just put it away, make it easy.

Why having an emergency fund comes with a cost?

First of all, I don’t mean having an emergency fund comes with a cost, I mean having a big emergency fund with a cost. Of course, you can invest all your money into the stock market, it could go up or down. When the market goes up, you make a profit. Then your emergency fund incurs an opportunity cost because you are not investing that money, therefore no profit for you.

For example, you have $24,000 saved as an emergency fund to cover 6 months’ expenses. Instead of $24,000, you decided to save up to $48,000 to cover one year’s expenses. But your partner is working, you don’t have debt, you have a sort of ‘stable’ income and insurances, and so on. Instead of investing $24,000, and keep $24,000 as an emergency fund, you put $48,000 in a savings account with a 0.5% interest rate.

Alternatively, you can invest $24,000 in ETFs and generate an annual 8% return (assumed return, benchmark Vanguard VT), which is $1920 per year, not including the compound effect. This $1920 is your opportunity cost when you put an additional $24,000 in your emergency fund.

You need to find a balance between securities vs. risks. Depends on your personal situation, you may or may not have to invest.

How to build an emergency fund?

If you don’t have an emergency fund or not enough to cover your desired duration. You should start contributing to it NOW! No matter how small it is, make it a habit to deposit certain about to your account and do not spend it.

1. Decide how much you need

Based on your personal situation, you can decide how big the fund should be: to cover your 3 months, 6 months, or 1-year living expenses? Or even 2 years? If you have unpredictable income, it is better to have more than less.

2. Expense audit

If you can to build up your emergency fund fast. I suggest you start with an expense audit. Go through your monthly living expenses category by category, ask yourself if you can optimize or reduce them? Most of the time you will be surprised that how much money you can save just by reducing some expenses and you won’t even notice it. Recently my brother-in-law lowered his internet and mobile subscription by $130 simply by searching then switching to a less expensive provider while having a faster internet connection. It is only a one-time effort, but he saves $130 more every month from now.

3. Automated deposit

Create an auto-transfer from your salary account to the emergency fund account. Make sure this money goes to the account once your salary account receives your salary. This way, it is out of sight, out of mind. It will slowly build up month after month. At a certain point, you can stop it and look into investing, if you want. If you did step 1, you will find yourself deposit a bigger sum every month because you will have more savings.

That is it. It is pretty straightforward. Everyone can follow the steps to build an emergency fund.

Do not use emergency funds for non-emergency situations.

Do not check your emergency fund regularly.

Do not use the same account with other things.

Do not start investing before you have built an emergency fund.

Learn the key money skills with the Fast Track Money Course.