Life is full of surprises, and some of them are expensive. Having an adequate emergency fund consisting of around three to six months of expenses allows you to maintain your lifestyle despite a medical emergency, sudden job loss, or other unexpected event. Creating an emergency fund before an emergency occurs may help you avoid long-term financial repercussions that would otherwise lead you to scramble to try to catch up.
Analyze Your Financial Situation
If you're not already following a monthly budget, there is a good chance you aren't fully aware of where your money goes or how much money you spend each month. Figure out how much money you spend in a typical month for all essential expenses. Based on that amount, your goal becomes saving up that amount multiplied by at least three. Three months worth of expenses is an excellent start to an emergency fund, but many financial experts, including Dave Ramsey, suggest six months worth of expenses as a fully funded emergency fund.
Add a Budget Line Item
Once you have your budget in place, add a line item for an emergency fund. The more you can add to the fund each month the better, keeping in mind debt also needs to be paid aggressively in order to be successful with an emergency fund. After all, a well-funded emergency fund will be invaluable during a period of financial crisis, but it's not nearly as effective when sizeable amounts of debt hang over your head. Ideally, keep debt low as you grow your emergency fund for the best financial outcome.
Make Monthly Contributions
Your budget should allow for monthly contributions to your emergency fund. Here are some helpful tips:
- Set an automatic withdrawal directly from your paycheck or checking account in order to simplify the process.
- Set up an account that is specifically for your emergency fund; it should be an interest-bearing savings account that is not used for anything else.
- Don't link this special account to your checking account; the urge to dip into the emergency fund as an overdraft protection can lead to problems.
- It's not advisable to keep your emergency fund as cash in your home. Money deposited into FDIC- or NCUA-insured financial institutions is protected, whereas cash can be lost or stolen.
Consider this monthly "payment" to your emergency fund to be just as important as any other monthly payment and, as such, give it appropriate priority.
Set Ground Rules for Emergencies
Decide what constitutes an "emergency" which merits dipping into the account. Keep in mind that this account is meant to be your insurance in the event of a financial emergency, and not a sum to be used when your budget is stretched thin due to lack of planning or because of overspending. If you get into the habit of withdrawing money from the account every month to cover groceries or gas for your car, it's time to revisit your budget and adjust your spending habits accordingly.
There may be months when you can contribute more to your emergency fund than others, particularly if your income fluctuates, but make it a strict rule that the money in your emergency fund isn't touched unless a true emergency arises.
Keep the Funds Accessible
You should be able to get to the money in your emergency fund without incurring any additional fees or penalties. That's why it's advised to keep the money in an interest-bearing savings account as opposed to a Certificate of Deposit (CD), a retirement account, or any other account which will either make it difficult to cash out or will result in fees or tax penalties.
So while you don't want the money in your emergency fund to be incredibly accessible (such as in your primary checking account or in a box under your bed), you do want the funds to be accessible without penalties for when you do need it.
Make Saving a Priority
Any unexpected crisis is made easier when you don't have to worry about how you will pay your mortgage or put groceries in the fridge. Ensuring your financial security is well worth the effort and should be made a priority in your monthly budget.