One of the most important steps to maintaining financial security is to establish an emergency fund. Building and emergency fund, along with paying down debt and reducing monthly expenditures, is probably one of the things most recommended by financial experts.
What Is An Emergency Fund?
An emergency fund is money that is set aside for emergency expenditures. The money should be in an accessible location, preferable a bank account and not under your mattress. You want the money available if you need it, not laying around so you can spend it.
A quick definition of what constitutes an emergency expenditure: car repairs, home repairs, medical expenses, expenses if you lose your job, or other large unplanned expense. A trip to NYC for a weekend of shopping is not an emergency. Without an emergency fund you may be forced to charge these emergency expenses to your credit cards and take on additional debt, putting you further behind.
How Much Should Be In Your Emergency Fund?
Most experts agree that anywhere between three to six months worth of living expenses should be in the emergency fund. If you are single with no dependants, you probable could get away with 2-4 months worth of expenses saved away. If you are married with a couple of kids you probably want to have 6-8 months worth of expenses. The more people dependant on you the more you should have in the account.
No one ever talks about if there is an upper limit to the amount you have in an emergency fund, but anything over 8 months is probably too much to put away in just a bank account. If you feel the need to have over 8 months of savings look to put some of the money in a conservative allocation mutual fund or a CD ladder.
As your life changes; marriage, kids, divorce, retirement for example, it would be good to review your expenses and compare that to the amount in your emergency fund. Even if you do not experience a change with your living situation, you should review your budget yearly and adjust your emergency fund accordingly.
Where To Keep Your Emergency Fund
The best place to keep the emergency fund is in an account that is separate from your normal savings or checking accounts. A critical requirement for the emergency fund is that the money is accessible or liquid, so get an account with check writing privileges, an ATM card or web/phone access for fund transfers. If you think you may spend the money too easily, get an account at a local bank with teller access only.
Below is a list of account types for an emergency fund with pros and cons:
Account Type | Pros | Cons |
Checking Account | Very Liquid Unlimited Access FDIC Insured | Low Interest Rate Potential for Monthly Charges |
Savings Account | Very Liquid Unlimited Access FDIC Insured | Low Interest Rate Potential for Monthly Charges |
Money Market Account | Liquid Slightly Better Interest Rates FDIC Insured | Limited Transactions |
Money Market Fund | Liquid Better Interest Rates | Limited Transactions Not FDIC Insured Could Lose Money (Market Risk) |
CD | Better Interest Rates FDIC Insured | Not Liquid |
Conservative Allocation Mutual Fund | Better Returns | Not FDIC Insured Not Liquid Could Lose Money (Market Risk) Management Fees |
No single account is the best for all people all of the time. If you have a small emergency fund, sticking with a bank or savings account probably makes the most sense. As you build your emergency fund look to a money market account or a money market fund.
How To Build An Emergency Fund
As with all things financial there is no quick scheme to build up with an emergency fund. It is best to plan for the entire amount that you need for your emergency fund and develop a plan to save that amount. If you estimate that you need $10,000 to cover 3 months of expenses, calculate what you can save each month to determine how long it will take you to build-up those funds. You will probably find that it may take a couple of years to save the entire amount. Don't worry, the important thing is to start. (A caveat to this, remember to re-evaluate the amount that you need each year. You may find that your expenses increase over time.)
The best way is to have a set amount of money each paycheck go towards your emergency fund. Over the course of a couple of months you can build a fund worth a couple hundred dollars. As you get additional money by working overtime, income from hobbies, birthday/holiday checks or selling things, put all of that money into the emergency fund.
What are you planning on doing with your tax rebate or stimulus package check?
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