Your emergency fund will protect you when life happens. Follow these simple steps to create and emergency fund and the peace of mind you need.
[Today's article is a guest post from Peter Creedon of Crystal Brook Advisors on the importance of creating an emergency fund and a simple strategy for creating a financial cushion.]
Hospital visits, pet illness, apartment leaks, car accidents, bad investments or job loss – life has a way of throwing all kinds of unexpected events at you without taking your budget into consideration. These events usually strike without warning and can put a huge dent in your budget. According to a recent study by Bankrate, 62% of Americans do not have enough money saved to pay for unexpected expenses.
That’s where an emergency fund comes to the rescue. An emergency fund is part of a cash reserve, which is simply extra money set aside to handle unexpected events that happen in your life. Many people know they should have an emergency fund, but few take the time to actually build one or know where to begin.
Fortunately, setting up an emergency fund can be pretty easy and doesn’t have to mean pinching every penny to do it. Follow these five steps to get you started.
Who should have a cash reserve emergency fund?
Unfortunately emergencies happen to everyone and you never know when one might strike. John Lennon may not have had emergencies in mind when he made his famous quote but they certainly do seem to come at the worst moments. If you’ve got financial goals, if you want your family to be financially secure and not have to worry about being wiped out by a roll of the die, then you need an emergency fund.
An emergency fund is just one of the critical steps to financial freedom. Get your free 12-step checklist to financial freedom and get on the path to security.
How much money should I set aside for my emergency fund?
Traditionally, I suggest your emergency fund should be between 3 to 6 months of monthly expenses. For individuals with uneven income and those who want a more secure cushion, that suggestion may increase to 9 months’ worth of expenses, just in case. Nine months worth of expenses might seem like a lot of money, especially when it’s parked in low-yield investments but ask any of the millions that were unemployed during the Great Recession, many of them for a year or more, and you may see things differently.
Having an emergency fund is about a level of comfort with your finances and knowing you’re secure. While unemployment continues to drop, we all need a little security from job loss. Unemployment insurance will only cover so much and for so long.
How do I start and emergency fund?
As with many of your financial goals, you may need to start small with your emergency fund if money is tight. Setting up an emergency fund is not something you absolutely must do overnight. Build towards a goal amount each month by budgeting a little towards the fund until it is fully funded.
Be strict with your budget and don’t touch the emergency fund unless there is an actual emergency. Resist the temptation to buy that new flat screen or smart phone, even if not having one feels like an emergency. The amount you set away depends on your income and your expenses – and be realistic. Set your target amount and try to work to it within two year’s time. If you’re planning on holding six months’ of expenses in your emergency fund, you would need to save about a quarter of your monthly expenses each month to reach your goal in the two years.
If saving a quarter of your expenses for an emergency fund is beyond your reach, try cutting a few items out of the budget on a short-term basis or move a portion of your investments to the fund. Check out a prior post on setting realistic goals and a budget you can keep if you need help getting started budgeting.
Where to park your emergency fund?
The most important item is where your emergency fund is held. It needs to be in an account that is easily accessible and stable. This is not the type of account where you are looking for maximum returns, safety is the primary objective.
It’s a tough concept for many to grasp. Why would you ever simply hold cash and earn close to nothing? Trust me, when you need money you’re going to be thankful it is quickly available. Usually a savings or money-market account are appropriate suggestions for an emergency fund. You may not be earning much in interest but the amount will not be subject to market losses like stocks and bonds. You know that you will always have at least as much as you put in.
A big mistake to make is to use your 401(k) as your emergency fund, but sadly many individuals do just that. Retirement plans are subject to market risk and early withdrawal penalties, which is exactly what you don’t want for your emergency fund.
How do I replace money I used from my emergency fund?
If you tap into your emergency funds, make a plan to set aside the amount of funds used and add it back to your emergency fund. This may mean cutting back on your monthly dining out budget to make up for the shortfall. Do not forgo your outstanding loans or skip the rent or mortgage. Remember, the purpose of an emergency fund is to keep you out of unnecessary debt.
Emergency funds are a lot like insurance. Few people really like to talk about them and even fewer actually like putting money into them every month. Like insurance, it may be years before you need your emergency fund but you will be extremely happy you’ve got it when you do.
Author Bio: Peter J. Creedon CFP®, ChFC, CLU is the founder and CEO of Crystal Brook Advisors, a financial planning and investment management firm. For over 15 years Peter has helped young individuals and businesses on the journey towards reaching their financial goals.