Emergency funds are like spare tires: you never think about them until you need one. This is an unfortunate truth for many people who don’t have a rainy day fund saved up for themselves. Some people fail to see the advantage in creating a fund, while others want to create one, but don’t know how.
Creating an emergency fund is more important, and more simple, than many people believe. The first thing to cover is why you need an emergency fund. This question can be answered easily by anyone who has ever needed one. Life is unpredictable. The situations that could arise causing a need for extra money are almost endless: healthcare, car troubles, emergency travel, the passing of a family member or, as many people have encountered in recent years, job loss. Things come up, things that you can’t see coming, and it’s much easier to roll with these punches if you have prepared for them in advance
Next we need to look at the how. The amount needed in this fund varies according to your situation and lifestyle. Contingency plans are most successful when you plan for the worst-case scenario, which in this case is probably job loss. You need to create a monthly budget of your expenses in case you suddenly find yourself with no income. This should include your rent, food, utilities, insurance, debt payments, prescription medications, cellphone bill and so on.
The bare minimum amount in your emergency fund should be equal to 3 months’ worth of these expenses. The overall goal is to have 6 months of expenses available to you in the fund. This may seem intimidating at first, but every little bit helps, so put in what you can over time, and aim for that target number.
Many people think that these emergency funds are best located in a box buried in the back yard or stuffed in their mattresses but, believe it or not, there are better options. The main requirement of the fund or account is that is must be easily accessible. Most emergencies don’t allow for the months or years needed to access money in some investment accounts. You should be able to access your funds within one business day. This is the case with traditional savings accounts or money market accounts. The drawback of these liquid investments is the lack of growth in those accounts.
There are other accounts that allow moderately quick access (less than 30 days) while still allowing you to earn money from the investments. One of these options is a bond mutual fund with either a short or immediate duration. These don’t offer the protection of other accounts, but can bring about modest growth without locking your money away. Investors must understand that their funds are vulnerable and can expect the value to fluctuate a bit. Many mutual funds also offer more flexible payouts directly to checking accounts, as well.
Another suggestion in creating an emergency account is to cut into your long term investment contributions. 401(k)’s and IRA’s are critical to your future in the long term, but if you are walking around with a great long term plan and nothing for the short term, you could find yourself in some trouble. This doesn’t mean you need to take thousands from your retirement contributions; $40-$50/month until you have yourself protected isn’t going to drastically affect your plans 30 years from now, but it could be lifesaving in just a few.
One of the easiest ways to protect yourself in an emergency such as a job loss is to take care of what expenses you can eliminate ahead of time. This means paying off debt. The debt on high interest credit cards can get a lot more painful if you don’t have an income. This not only cuts down on your expenses, but if you’re paid up to date, you allow yourself some room if you need to use those credit cards as a last-resort source of financing in an emergency.
The two most important aspects of creating an emergency fund are having the foresight to know you might need one and having the discipline to be able to create one. If you have those two things, the rest is easy. Just account for your monthly expenses, plan an account to funnel money into, and budget your income to allow that account to grow.
