What would happen if you lost your job? Could you survive without your income for two or three months? For many people, it's a scary question. An emergency fund will help you feel better about the unexpected changes in life.
Money tucked in your emergency fund should be used only in emergencies. Redecorating the kitchen isn't an emergency, but replacing cabinets after a kitchen fire is one. A summer vacation? That's definitely not an emergency. Fixing your car when it strands you on the highway? That counts. Consider whether you need to spend the money in order to survive or simply because you want to keep up your lifestyle. There's a big difference.
Next, decide how much you should have in it. Deciding the exact amount of money to set aside is a personal decision that you should make based on your budget. A good estimate is enough money to get by for two to three months without any other income. Decide where you'll keep the money and what other spending you may need redirect to your emergency fund.
Saving may be difficult, but it's worth the effort. An emergency fund can more than pay for itself -- especially if it's the buffer that keeps a medical catastrophe from sending you to bankruptcy court. Read on to learn more about preparing yourself for a financial hardship.
Calculating Your Emergency Fund
Calculating your emergency fund isn't difficult, but it takes careful planning. First, evaluate your income to determine how much money to save for the unexpected. If you've already created a budget, you know how much money you usually bring home in a month. Multiply that amount by three to determine the amount you'll need to get by for three months without pay. If you don't have a budget, you should write down every dollar you get for the next eight weeks, and divide that amount by two. This will give you a good estimate of how much money you make each month. You'll soon have your budget and feel much better about your finances.
Next, calculate average emergency costs. You know how much you normally spend, but in an emergency, you'll probably have additional expenses. If you're out of work because of an accident, you'll probably have some medical expenses to pay, on top of everyday living expenses. Allow enough money to pay the medical bills that your health insurance won't cover. See your insurance plan's Summary Plan Description for a good idea of the costs you'll be responsible for in the event of various medical emergencies. Or, if something happens to your home, you need to be prepared to pay your bills while you're making other arrangements. Your homeowner's insurance should cover the costs of replacing your home and valuables.
It's also important to know your cost of living. Living on your budget now can be tough. Living through a time of crisis will probably be tougher. Allow for the cost of living during such a time, knowing that your expenses will be greater than they are now. Your emergency fund should contain enough money to let you live through a disaster until your life returns to normal. You probably won't live at the same standard you enjoy now, but you can pay your mortgage and keep your car until you get a new job or recover from a sickness. The overall goal is to have survival cash, not fun money.
Of course, there is always the question of where to keep the money. On the next page, we'll explore the best ways to start your emergency fund, where to keep it and how to get the money for it.
Starting an Emergency Fund
Because it may require a tight budget, starting an emergency fund can be a daunting task. Once you know how much you need, you have to figure out how to accumulate the money. You may have to cut back on some discretionary expenses like eating out or buying a new pair of shoes every week. But knowing that you have a safety net can make it much easier to make the sacrifice.
One way to start your emergency fund is to set up an automatic draft so that a part of every paycheck goes into your emergency fund. If you never see the money, you won't miss it, and you won't be as likely to spend it elsewhere.
Be sure to set up a separate account for your emergency fund. Don't make it a checking account -- that makes it too easy to use the money for other things. Make sure it isn't attached to an ATM card or any other easy-to-access features. You want to get to the money if you need it, but not just because you found a set of bedroom furniture you couldn't resist.
Using a money market account for an emergency fund can help you make money on your savings while you aren't using it. Money markets draw more interest than basic savings or checking accounts, and you can still get to the money if you need it.
Don't be disappointed if your emergency fund takes a long time to build. Set up a plan for how much you'll contribute to the fund each month based on the amount of time you want to allow for building the balance. If you try to reach your goal too quickly, you'll either miss the goal and get discouraged, or you'll have to give up all the fun and entertainment in your life in the name of savings.
People think very differently about emergency funds. Some advisors suggest deferring 401(k) payments for a few months to get an emergency fund going; others say that the loss of long-term 401(k) benefits far outweighs the benefits of an emergency fund. Research 401(k) plans and determine for yourself how important the emergency fund is to you.
If you work at it, you can build a fund large enough to provide a safety net that will last several months. It can help you feel better about tomorrow, knowing that you are prepared to face a crisis, should one arrive. And if you don't face a crisis, you can feel good about having a nest egg. Either way, getting started on an emergency fund is a step in the right direction.
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More Great Links
- Brewer, Philip. "Figuring the Size of Your Emergency Fund." http://www.wisebread.com/figuring-the-size-of-your-emergency-fund 10/9/07 (5/15/08)
- Bruce, Laura. "Building an Emergency Fund." http://www.bankrate.com/brm/news/pf/20011105a.asp?caret=2 12/29/06 (5/14/08)
- Dunleavey, M.P. "Save your 'emergency fund' for the real thing." 6/27/07 (5/14/08)
- J.D. "How and Why to Start an Emergency Fund." http://www.getrichslowly.org/blog/2006/09/08/how-to-start-an-emergency-fund/ 9/08/06 (5/14/08)
- Weston, Liz Pulliam. "The $0 Emergency Fund." http://articles.moneycentral.msn.com/SavingandDebt/LearnToBudget/The0EmergencyFund.aspx?page=1 1/18/08 (5/14/08)