Life Insurance vs. Emergency Fund: Why You Probably Need Both

When the worst happens in life, you or your loved ones ideally need funds to fall back on. But how best to ensure money is there when it’s needed?

Two leading options are to build an emergency fund to cover unexpected expenses when you’re alive, or to invest in a life insurance policy that pays out when you die. Many people will need both forms of financial protection, but how best to decide how and when each should be funded?

Understanding when an emergency fund and a life insurance policy comes into play — and how to potentially afford both — will help you prepare for the future. Here’s a rundown of the best role for each of these financial sources, with tips on when and how to arrange for each.

The role of an emergency fund

No matter how careful you are, life has a way of throwing hurdles and hiccups in your direction. Whether it's a flat tire, a broken appliance or a pet that needs emergency veterinary care, an unexpected expense can easily burn a hole in your finances.

An emergency fund helps you cover those unforeseen setbacks without having to rely on increasing your debt. A fund can also help in the event of an unexpected loss of income. If you’re let go from your job or your hours are cut, that emergency balance can help you pay for essential expenses, such as your rent and utilities, and so give you time to get back on your feet.

Ideally, an emergency fund's balance should be enough to cover between three to six months' worth of expenses. If that goal sounds all but impossible, start small; any amount is a good starting point. Over time, you can build your savings month by month until you meet that goal.

If you're wondering how to start an emergency fund on a tight budget, these tips may help:

• Sign up for a high-yield savings account (HYSA): A HYSA pays a higher rate of interest than other savings accounts, which can help your money to grow faster.

• Track your spending: Creating a budget and tracking your spending can reduce the number and value of the unnecessary or impulse purchases you make, freeing up more cash for your emergency fund.

• Get a side gig: If money is tight, you may need to boost your income to have enough cash to build an emergency fund. A side gig can be a good way to increase your income during your free time.

The purpose of life insurance

Some people use life insurance as part of their estate planning and to build generational wealth. But the most prevalent purpose of life insurance is to provide for those who survive you after you die.

If you were to pass away suddenly, life insurance aims to help your loved ones cover expenses without your income. For instance, if you have young children, a life insurance policy could help pay the home mortgage and your children's college education.

Life insurance needs vary by the individual, of course, but one general guideline is to purchase a life insurance policy with a death benefit equal to 10 to 15 times your annual income. For example, if your salary is $60,000 per year, you would buy $600,000 to $900,000 in coverage.

That might sound like a huge purchase, but term life insurance — the least expensive form of life insurance — may be more affordable than you think, especially if you buy it when you’re relatively young. For example, the monthly price for a $250,000 20-year term life insurance policy can be as little as $15 or so for a healthy 30-year-old, whether male or female.

Insurance vs. fund: when each option is needed

Emergency funds and life insurance policies provide critical protection. In some circumstances, you may need both. When deciding which you need, ask yourself the following questions:

You most need an emergency fund if:

• You work in a volatile industry: If you're employed in a field that is particularly prone to market changes or layoffs, such as finance or technology, you're more likely to have a lapse in employment, and it may take longer to find a job. You likely need a larger emergency fund than workers in other fields.

• You lack multiple streams of income: You'll be better able to weather financial storms if you have sources of income other than from your own job, such as a spouse’s salary or earnings from a side business. But if you lack such supplemental income, and rely on a single paycheck, an emergency fund will be especially important to ensure you can cover your bills.

• You'd struggle with an unexpected expense: Besides coping with job loss, an emergency fund helps pay for expenses you didn't anticipate. If you have little to no financial cushion now – say to repair your car if it breaks down or for travel to be with a sick loved one – it’s all the more important that you build an emergency fund that’s sufficient to cover such out-of-the-blue expenses.

You most need life insurance if:

• You have children: Life insurance is an essential component of protecting your family as parents. A life insurance policy ensures there are funds to help pay for the care and education of your family if you were to pass away unexpectedly.

• You have a non-working spouse: If your partner stays at home, they're dependent on your income, so you need a life insurance policy to provide for them in the event you pass away.

• You have other dependents: Even if you don't have children, life insurance may still be a necessity. If you have other dependents or those who rely on you for financial support — such as an elderly parent or a sibling with a disability — life insurance can provide for their continued care after your death.

Protecting your finances

Emergency savings and life insurance may compete for your limited funds, but each has its own role within your finances. An emergency fund can help cover unexpected expenses or income loss, while life insurance helps make your loved ones financially whole in the event of your untimely death.

It’s true that a sizable emergency fund – one that contains three to six months of income – can help fill the gap in the event of your unexpected death. But the extent of that help is likely fairly modest – at most in the five-figure range. That falls well short of the six figures that’s generally recommended for life insurance, under the formula that a policy's death benefit be 10 or more times your annual income.

The upshot: More than likely, both emergency funds and life insurance should play key roles in your financial planning. When it comes to these cornerstones of personal finance, few families need only one.

A final tip, if you happen to be holding more than six months of expenses in your emergency-fund savings account: consider directing the excess funds to a vehicle that earns you more, like an investment account.