Building a Healthy Emergency FundSubmitted by Desmond Wealth Management, Inc. on October 16th, 2015
An emergency fund is an essential element in every person’s financial health. Even seemingly wealthy people with high incomes can be living paycheck to paycheck with almost no ability to absorb unexpected expenses. A 2011 survey conducted for the National Foundation for Credit Counseling found that 64% of Americans wouldn’t be able to cover an emergency expense in excess of $1,000 without a loan or a cash advance. And those cash advances can cost you big time, usually to the tune of 20%-30% interest.
If you have no emergency savings, where do you start? Look at your spending habits and determine areas where you could trim your spending. Make a list of all your short-term high interest debt and pay off these obligations first.
Maybe you have a small emergency fund set aside, but you want to save more? Follow these steps to get a strong emergency fund up and running.
- Define “emergency fund.” The first step along the way is to understand: what actually is an emergency fund? An emergency fund is cash that you’ve saved up for the sole purpose of helping you to maintain your normal life through any emergency that life may hand you. Most of the time, you shouldn’t touch the emergency fund at all – it just sits there earning a bit of interest and waiting until you actually need it. When an appliance breaks down, your car needs some repair, you lose your job, or when you need to leave your job, having an emergency fund provides you with room to breathe.
- Pay yourself first, make it automatic, and start small. Remember that $1,000 that two-thirds of Americans can’t cover? Why not start there? Most banks will let you open additional savings accounts. Have your bank open a new account for you that is only for your emergency fund. Set a monthly savings goal that will get you to $1,000. Start now and pay yourself first, have it taken directly from your paycheck and automatically deposited into that separate account. The most important thing is to get started. Chances are that you will not even miss it.
- Set a bigger, longer-term goal. Now that you have your initial fund set up, take some time to set a long-term goal for your emergency fund. You should keep in mind that you may need to access it at some point in the process. A good minimum is cash equal to three months of non-discretionary expenses. After that, it depends on your situation. Someone who works in sales and relies heavily on commissions may want to build up a fund able to cover expenses for six to nine months, or longer. A dual-income couple, who both work in stable industries, may be comfortable staying closer to three to six months. Reaching this goal may take several years of saving. Add a strict savings goal to your monthly budget and stick to it.
- Find the right vehicle for this account. Where to grow the emergency fund presents an interesting dilemma for most. It usually represents a large amount of cash that you need readily available, but as most advisors will tell you, sitting on cash is actually counter-productive. Your savings account may earn less than 1% per year, and yet inflation has averaged over 3% per year over the past few decades. Keep a minimum amount readily accessible, maybe your first three months’ worth. After that, with funds that wouldn’t be needed in the short-term, seek out low-risk investments that can earn more than your savings account, such as a money market fund, short-term CD or ultrashort bond fund. In an emergency, you’d still be able to access these funds, although you’d have to pay a penalty for making a withdrawal from a CD prior to maturity.
- Adjust as needed. To repeat: Take money out of your fund only in an emergency. That said, chances are that over time, your monthly expenses will grow – so then should your emergency fund. Also, when you do use money for an emergency, make it a priority to get the fund back up to its target level as soon as possible. Just as before, this may take months or years depending on the expense, but it should still remain a priority.
Your emergency fund is a safety net for you and your family. It should help you sleep better at night. Emergencies happen unforeseen. Being able to meet these needs without ruining your financial health is both practical and beneficial to achieving your long-term financial goals.