Congratulations, you’ve either paid off all your high interest credit card and revolving credit debt (or are well on your way) and you’re ready to start building your own emergency rainy day fund. A what, you ask? Rainy day funds or emergency funds or financial security blankets are some of names given to a stash of cash you keep locked away to cover your living expenses for 6 months or more.
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What An Emergency Fund Is
Oh yes, that emergency fund! “The experts” differ in their opinions of how much of a fund you will need. Recommendations range from 3 months, which is too little, and 12 months, which is probably not realistic, which leaves us with the goldilocks goal of 6 months. Your emergency fund should be equal to your 6 month net income plus expenses that would be covered by your employer such as health care.
Why You Need One
The purpose of the fund is to cover your living expenses in the event you lose your source of income or to fund some personal catastrophe such us a serious illness that is not completely covered by insurance. This is not a “I really want to go to Europe for 3 weeks and stay at 5 star hotels fund.” This is for real emergencies and if you are fortunate you will never, ever need to touch it.
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On that note, you should have separate funds for saving to buy a home or take a vacation. The emergency fund should not be combined with your savings for college or graduate school. Keeping the money for different goals separate will reduce the temptation to dip into the emergency fund.
Where To Keep Your Emergency Fund
Where to keep your stash is the question most people ask next? There are two versions of the answer to this question and we’ll begin with where not to keep your emergency funds. The stock market, CDs or any investment that has early withdrawal penalties are all unacceptable places to lock-up you loot. The reason is because emergencies are unexpected and unplanned events so why compound the crisis by subjecting yourself to the stress of dealing with penalties. You should be able to access your emergency fund easily and quickly.
An equally unsound place to keep your fund is under the mattress either literally or figuratively. While you want your emergency fund to be liquid, a false bottom in your sock drawer is not a good idea. It, along with a safe secreted away in a basement closet not only does not earn interest but is subject to loss or destruction. You can rest assured that if I know about the false bottom in your sock drawer so do thieves. Plus fire or natural disasters can blow or wash away your fund.
A passbook savings account is a safe place to stockpile your savings but currently they earn little interest. They have the advantage of being liquid and insured, see FDIC limits. The funds can be withdrawn in whatever size increments you need and most importantly as needed. So there is no need to cash out and keep large sums of money in that sock drawer.
Growing an emergency fund does not mean you have to give up any and all sense of financial savvy for the sake of guaranteed security. Money market accounts may well be your best bet for your fund. They can earn a decent interest rate (decent is a relative term, when compared to a day to day savings account) and they are liquid.
Many money market accounts operate like a checking account, which in the event you need to access your funds is perfect. You can write checks directly against the balance or instruct creditors to debit your account directly. Because these funds do earn interest they tend to fill up faster. Once you reach your goal you can leave the accumulated interest in to cover inflation and your increases in salary so that the fund can become self perpetuating.
How To Do It
Putting the money away is a numbers game and a question of your willingness to sacrifice a little today for security tomorrow. Since we never know when an emergency is going to happen, the ideal solution is to build your fund as quickly as possible. The ratios are straight forward. Putting away 10 percent of your monthly net income will have your fund full in 60 months, while 5 percent will take 120 months and 20 percent, 30 months.
Whether you pick your favorite aphorism such as “an ounce of prevention is worth a pound of cure” or “put your nose to the grindstone” and “getter done”, the bottom line is if and when your rainy day comes you’ll be glad your wore your financial rain boots.
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