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Another Post on the All Important Emergency Fund

I know it may seem like we are harping on this subject but it really is that important. Without some spare cash the smallest unforeseen circumstance is an emergency. With enough cash in your bank account it is just an inconvenience. So which do you prefer emergency or inconvenience? ~Tim McMahon, editor

The Importance of Saving Up for an Emergency Fund

Savings- ID-100449264Imagine it’s Christmas Eve. You’re just about to arrive at the family home after driving for 10 hours straight across 3 different states. Your wallet is feeling a bit light after all those gas station stops and the presents you bought before the trip. Suddenly you hear that terrible sound we all fear; rattling coming from your car’s engine. The repairs will cost $900, but you don’t have the cash and you won’t get paid again until next month. What now? If you had an emergency fund, you would already have the answer.

Why do I need an Emergency Fund?

Building an emergency fund is one of the most important tenets of responsible financial planning. Life is full of surprises outside of our control and often those surprises are costly. Emergency scenarios can range from mild annoyances to serious and even life threatening situations. It could be the case that your hot water heater breaks down, leaving you stuck with cold morning showers. Or alternatively, your AC unit stops working in the middle of summer. Even worse, you could find yourself straining from the burden of a high deductible or co-pay while waiting for treatment in the ER. Emergency situations can be serious without being life threatening as well, such as needing an expensive plane ticket to get to a loved one’s funeral on time.

All of these scenarios are as stressful as they are costly. But you can do yourself a favor and reduce some of the stress by preparing ahead of time. Remember that the purpose of an emergency nest egg is to make your life easier, not harder. Not only can you reduce the stress of an emergency by saving ahead of time, you can also save yourself more money down the road. The purpose of your nest egg is not for travel or leisure. You should only be using this money for actual emergency situations. Blowing your emergency cash is financially irresponsible and defeats the entire purpose of saving in the first place.

Short Term Emergency Fund

You should focus on building a short term emergency fund first. This little nest egg will be your first line of defense against sudden expenses that you need taken care of immediately. The car repair scenario is the perfect situation for a short term emergency fund. If you have to get back to work sometime soon, you’re going to need those repairs as quickly as possible. With a nest egg of $2,000 in your bank account, you could easily take care of the car repair expense and move on.

Your short term emergency fund should be smaller than your long term emergency fund. You’ll need to be able to access this account quickly in order maximize its use. An account that takes a day or more to access is not a short term emergency fund at all. You need immediate access. This will likely take the form of a checking account. A checking account with either a debit card or checks attached is the most common haven for these kinds of fund. Not only will your money be FDIC insured and kept safe, but you will be able to access those liquid funds immediately when you need them.

Long Term Emergency Fund

Building a long term emergency fund takes discipline, time and patience. The general rule of thumb for the size of a long term emergency fund is at least six months’ worth of your expenses. Please note that you should be saving six months’ worth of expenses, not income. Expenses include things like rent, mortgage payments, household upkeep, utilities, transportation, food and healthcare. According to the Bureau of Labor Statistics, Americans’ average monthly expenditures came to $3,786 in 2014, as they say “your mileage may vary”, but it should give you a general idea of where to start.

As you can tell from the name, a long term emergency fund is designed to keep you and your family going when things get really bad. A more simplified way of measuring the size of your long term nest egg is by asking yourself how much money will I need to survive and meet my obligations for six months? Your long term funds don’t need to be as liquid as your short term funds, but you should implement both to be safe. You probably won’t want a large chunk of money just sitting around in a bank account when it could instead be earning some interest. But remember the purpose of saving this money in the first place; to have a quickly accessible lifeline when you really need it. Avoid investing your long term emergency fund into stocks or other volatile or illiquid assets so you will be sure it is there when you need it. Instead, you could look to low risk bonds that can be sold in just a few days. You could also consider a CD ladder as part of your emergency fund for a low risk and easily accessible alternative.

Building Your Emergency Fund

  • Review Your Finances: Detail all of your essential expenses for one month. Ask yourself how much money you will need to survive and if you have any debts that need to be paid off first. Also imagine realistic emergency situations you may find yourself in. Do you think there’s a chance you may lose your job in the near future? Has your car been acting up lately? What about your loved ones, are they getting further into their twilight years?
  • Trim the Fat: We all waste money on occasion. Find a pattern in your spending habits and see what you can cut out. Be honest with yourself and don’t make excuses. Then take those savings and pass them into your emergency fund. Setup a regular schedule and remind yourself each month to fulfill your emergency fund contribution.
  • Prepare: Now that you have a plan, you’ll need to execute it. If you don’t already have a checking account, set one up. Make sure your assets are liquid, meaning you can access them immediately. Add a debit card to your account for easy access. Decide the size you would like your emergency fund to be and make sure you reach your goal. Whatever the size, that’s your account’s new zero point.
  • Pat Yourself on the Back: You did it! Give yourself a small reward every time you reach a major milestone. You’re on your way to financial independence and safety.

What if I’m Currently in Debt?

If you’re one of the many Americans currently struggling with debt, you’ll have to make a few considerations first. Before building your emergency fund, you need to pay down your high interest rate loans and credit card balances first. Tax debts and high interest rate debts will skyrocket out of control if you do not manage them responsibly, which means your first priority is ensuring this doesn’t happen. Although an emergency situation can end up being costly, high debt and interest rates will end up being even more costly. Once your debt is manageable then you can proceed with building your emergency fund. However, if your debt is unmanageable, you should consider a professional debt settlement service. This is especially true if you’re dealing with tax debt or unsecured debt, which is much more difficult to manage. Don’t begin saving until you can keep up with all of your debt payments and your remaining interest rate payments are less than the interest you could earn on your savings.

Debt management and settlement combined with saving up for an emergency fund are among the most fundamental building blocks of financial responsibility and independence. Don’t hesitate to get the ball rolling. Start now and reap the benefits far into the future.