No one has to tell you that emergencies come. You’ve probably experienced a few of them yourself. What you might not have known is that you should always have some money set aside to cover the expense of an emergency. This type of savings accounts is called an emergency fund. It’s a stash of money that you use, well, for emergencies. You don’t buy birthday gifts with it. You don’t use it to make renovations to your home. You only touch it in true emergencies.
“But I have a credit card that I can use for emergencies,” you might say. Putting emergencies on a credit card can get expensive, especially if you have a high interest rate on the credit card and you only make minimum payments on the balance. Not only is credit card debt expensive, it could affect your credit score since your debt level is 30% of your score calculation.
What do you do if you don’t have a credit card you could use to fund the emergency?
Why Have an Emergency Fund An emergency fund is the best, and least expensive, option to protect your financial health from unexpected disasters. If you lose your job, you can rely on your emergency fund to help meet your living expenses until you get a new job. Severance packages and even government unemployment benefits aren’t always enough to pay your rent/mortgage, utilities, car note, and other monthly expenses. They’re not guaranteed either. Having some money stashed away in a savings account will be your umbrella on a rainy day.
How Much Should You Save While most experts agree that you should have an emergency fund, they don’t agree on the amount. Some say $1,000. Others say up to a year’s worth of a salary. The truth is the amount is different for people in different situations. Generally, three to six months worth of living expenses would be a great emergency fund.
How to Build an Emergency Fund The simplest way to build an emergency fund is to open up a separate savings account and start putting money in it every month. An online savings account is a good idea since you can’t directly access the money, but can transfer it when you need it. Get an account that earns interest so the money isn’t just sitting there. Don’t store your emergency fund in an account that penalizes you for withdrawals, e.g. a certificate of deposit (CD) or 401(K).
Before you start making deposits to your emergency fund, make sure the money you’re stashing away isn’t money you should be sending to the electric company. Review your monthly budget to see how much you can actually afford contribute to an emergency fund each month. Then, once you’ve come up with an amount, adjust your budget to reflect the decrease in spending money, and open up your savings account. If your company allows it, have part of your paycheck direct deposited into your emergency fund. That way you never “see” the money and won’t feel like you’re parting with it.
Once you’ve built your emergency fund to a level you feel good about, you can start putting the money you were saving toward something else, like paying off a credit card bill. If you spend from your emergency fund, be sure to put the money back so you’ll have enough for a future emergency.