7 Tips for Building an Emergency Fund
When it comes to establishing financial security, emergency funds top the list. Unexpected expenses are common. That’s where an emergency fund can help. Without one, costs tend to go on credit cards, rather than from a savings account, preventing you from building your net worth.
The first question generally asked is “How much should I save?” The experts do not agree on a set amount: Prior to 2008, the standard was 3 to 6 months’ worth of expenses was the standard to cover emergency events like loss of income or medical emergencies. Now that number has been bumped up to a recommended 6 to 8-month surplus of funds that are easily available.
Many consumers struggle with the idea of setting aside thousands of dollars in low interest earning accounts. To combat this, consider creating both a short term and a long term emergency fund that will accommodate the need for growth while also granting you some funds to immediately access when needed.
For the short term account consider how much would be required if the car broke down or you needed to make a home repair. Think about one time emergencies that might arise, that could not wait a week for funding. Set aside that amount into a savings or money market account that you can get to the same day. The remainder of your anticipated emergency fund could be established in an investment account that has higher earning power and can be liquidated in a week or so. This would be reserved for an event like a job loss or a natural disaster that would require funds over a longer period of time.
The question then becomes how do you go about saving enough money to fund an emergency account?
- Determine how much you need to save with a focus on expenses and not income. If you lose your job extra expenses like vacations and new clothes will no longer be a part of the budget. Mandatory expenses like paying the mortgage and keeping the lights on will always be there and must be covered whether you are working or not. What is the minimum you would need to survive and keep all payments current? Use that figure to calculate want you need for an emergency fund.
- Start Small. Setting a goal of accumulating $20,000 or more is daunting when you don’t even have $1,000 saved. Set small incremental goals with a time limit. For example: set a goal to save $500 in the next 3 months or 6 months, depending on your budget abilities. Even if you have existing credit card debt, set aside a small amount of money each pay period to work towards building your savings. It is nearly impossible to get out of debt without an emergency fund to cover unexpected expenses. You pay off $500 in debt, and then car repairs require you to re-charge that amount. It can feel like two steps forward and three steps back when this happens frequently. Having a savings to tap into will prevent this cycle.
- Make it accessible, but not too accessible. Opening a savings account at an online bank or a credit union will both physically and psychologically separate the money from your day to day budget. This step reduces the temptation to tap into it over convenient purchases rather than emergencies. You do not want to be able to get to the money with a few clicks, yet you could get the debit card out of the drawer and access it in a true emergency.
- Automate the process. Setting an auto draft into your savings account is an effective way to make this happen. If your goal is $500 in six months and you get paid twice a month, auto draft $38 each paycheck into the account. You will be surprised that you will not even notice it is missing from your account.
- Only use for an emergency. An emergency is not your annual property taxes or your quarterly home insurance payment; an emergency is not a great sale at your favorite store. These are anticipated expenses which you should already have a plan in place to pay. Setting aside funds each month to cover anticipated expenses will allow you to have the money to pay the bill when it comes due. Having a separate account for intermittent bills can be an effective way to prepare for these costs as they occur. Vacations and holiday spending should be covered in the working budget. Another option is to stagger the payments so one quarterly bill comes due each month enabling you to work them into the monthly budget. Reserve your emergency fund for true emergencies such as car repairs, a funeral you must attend, or replacing a broken appliance.
- Take advantage of windfalls like bonuses and tax refunds to jump start or add to the account. It can take years to build up a 6-month reserve at $50 a paycheck. Adding a percentage of any extra funds will get you to your long term goals faster. For example: Taking 40% for debt reduction, 40% for the emergency fund and 20% for other wants will create a spending plan when extra funds arrive. Knowing ahead of time how the money will be divided will help keep you on track.
- Find hidden money. Finding hidden money will speed up the process and help you see results faster, when budgets are tight, or you want to get on the fast track for savings or debt reduction. The easiest way to identify extra money in your budget is to track spending for 30 days and find places where you can cut back. Look over each monthly bill and see if there are extra charges that can be eliminated: Do you pay insurance on your phone? Companies like Square Trade can be half the price of insurance provided by carriers for the same coverage. Do you pay for premium channels on your satellite bill? A Netflix account will offer you the same options for less. Instead of eliminating all your extras, find ways to get the same services cheaper.
Creating an emergency fund is like carrying personal insurance for your needs. You buy health insurance to cover healthcare emergencies. You have car insurance and home insurance in the event of accidents or natural disasters. An emergency fund can cover costs associated with deductibles, repairs, and other life events you cannot anticipate. You hope the account will grow for years without ever being needed, and then it will be available when disaster strikes, providing peace of mind and financial security.