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 six months or more.
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 three months, which is too little, and 12 months, which is probably not realistic, which leaves us with the Goldilocks goal of six months. Your emergency fund might need to be equal to your six month net income plus expenses that would be covered by your employer such as healthcare. A savings calculator can show you how quickly your money can grow to reach this ambitious goal.
Why You Need One
The purpose of the emergency 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 three weeks and stay at five-star hotels fund.” This is for real emergencies and if you are fortunate, you will never, ever need to touch it.
On that note, it’s a good idea to 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 emergency fund is the next issue most people consider. The stock market, CDs or any investment that has early withdrawal penalties are all unacceptable places to lock up you loot. That’s 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. Fires or natural disasters can easily blow or wash away your fund.
A passbook savings account is a safe place to stockpile your savings, but it probably won’t leave you with much interest. They have the advantage of being liquid and insured. The funds can be withdrawn in whatever increments you need. 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 checking accounts. You can write checks directly against the balance or instruct creditors to debit your account directly. Because these funds earn interest, they tend to fill up fast. Once you reach your savings goal, you can leave the accumulated interest in your account to cover inflation.
How to Do It
Putting 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.
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 your rainy day comes, you’ll be glad your wore your financial rain boots.
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