October 2012

Building an Emergency Fund

The harsh reality of today's economic climate is that many people are just one job layoff or one serious medical emergency away from financial disaster. Unexpected financial needs always seem to happen at the worst possible moment and when people are the least prepared for them. For individuals who are literally living from paycheck to paycheck, one unplanned bill or other financial need can cause "just scraping by" to turn into a full-blown monetary crisis.

This is precisely why experts agree that having an emergency fund is absolutely critical to successfully navigate today's turbulent waters caused by rising consumer prices, high unemployment, and overall job insecurity. If you are like most American consumers, you probably use a credit card to pay for a car repair or to replace a broken water heater. However if your credit cards are completely maxed out, you may find that you have very few options when the next unplanned financial need occurs.

So let's discuss some practical things you can do to start building an emergency fund. The first thing to remember is that this is an actual emergency savings account. Money that you accumulate in this account is meant to be used strictly for emergencies not for a new flat screen TV or vacation getaway. It's perfectly fine to have a separate savings fund for special things you might want. But an emergency fund is for emergencies only.

Most financial experts suggest that six months worth of living expenses should be the minimum amount of cash funds to have in an emergency account. If you are a contractor or self-employed, it is recommended that you have at least twelve months worth of living expenses saved up. This may sound like an impossible task if you are living paycheck to paycheck, but it can be done. Here are some suggestions to help you get started:

  • Know where your money is going. Go over all of your expenses- mortgage (or rent), car payments, insurance, utilities, food, etc. To determine what the amount should be in your emergency fund, take your total living expenses and multiply that number by 6 (for 6 months) or by however many months you want to plan for. Obviously, the more the better.
  • Cut expenses. Once you figure out what you are spending every month, it's easier to see where you can make cuts. Start with something simple. Take your loose change every night and put it into a jar. It adds up! Eating out is nearly always more expensive than eating at home. Don't renew magazine or newspaper subscriptions. Almost every publication is available online at little or no cost.
  • Put away your credit cards. Saving is much easier when you live on a "cash-only" basis. Studies have found that people are more cautious about making purchases when using cash to pay for them. Take the money you have been giving to the credit card companies and put it into your emergency fund.
  • Set up an automatic payment. Check with your employer or bank to arrange for an automatic deduction from your paycheck to be deposited into your savings account (emergency fund). Many people find it easier to save when they never see the money in the first place. Start with 5% and then increase the amount when you are able to do more.
  • Find the best interest rates. When you are just starting to save, you will probably want to have your money in a money market account. You won't earn much interest but your money will be safe and you will have access to it. Once you have two or three months worth of living expenses saved up, you can look into getting some type of CD (Certificate of Deposit) which has a higher interest rate.
  • Don't touch your emergency fund. It's important to learn the difference between a "want" and a "need". Buying a new dress or purchasing the latest electronic gadget is not an emergency situation. Unless you literally have no food in the house or are about to be evicted from your residence, leave the emergency fund alone!

If you have never had control over your spending or been a saver, funding an emergency savings account can seem like an overwhelming task! But the rewards of being financially independent and properly prepared for life's unexpected calamities are well worth it. The most important step (and maybe the hardest) is just to start. You'll be glad you did.