Published March 10, 2011
Avoid Financial Ruin
Life rarely goes as planned. That's why it's always good to have an emergency fund in the bank.
Brad Smith, CEO of debt management company Rescue One Financial, in Irvine, Calif., works with more than 100,000 clients trying to avoid bankruptcy.
"Many of them could have avoided enrolling in a debt management plan had they had any type of emergency fund set up," he says. "There are many people out there who are living so paycheck to paycheck that a blown transmission would send them into bankruptcy. An injured child or a natural disaster could easily be handled with additional funds."
Avoid letting unexpected expenses or events lead you to financial ruin. Build your emergency fund by using these tips.
Determine How Much You Need
Start building your emergency fund with a specific goal in mind. While your savings goal will depend on your income and expenses, a general rule of thumb is to save enough to cover four to seven months' worth of expenses.
"Everyone has wants, needs and desires when it comes to spending money," says Pete D'Arruda, financial radio show host, author and president of Capital Financial Advisory Group in Cary, N.C. "Make sure you have seven months' worth of emergency income available for the needs."
Kevin Gallegos, vice president of Phoenix operations for Freedom Debt Relief, says to focus on having enough to cover expenses when setting your savings goal, not on replacing your entire income.
"Remember, in an emergency, we don't fund vacations, fancy new clothes, dining out or other luxuries," he says.
While you may aim higher eventually, Smith recommends making small goals at first, such as saving $1,000 and working your way up to a reserve to cover several months' worth of expenses.
Decide Where you Will Keep the Fund
Your rainy day emergency fund should be easily accessible, but not so easily accessible that you'll be tempted to make withdrawals for everyday spending.
"I like using an account away from my normal checking account to build a psychological wall between my spending habits and my emergency fund," says Ray Lucia, a Certified Financial Planner and nationally syndicated radio host. "Credit unions work well because they normally allow you to start with smaller amounts of money."
Online banks also are good locations for your emergency savings account because you can't just walk into the bank and withdraw your cash.
Danielle Marquis, adjunct professor of personal finance at Red Rocks Community College in Lakewood, Colo., recommends keeping emergency funds in a combination of locations and/or saving accounts, including an online savings account, in savings bonds and as cash in a lockbox at home.
If you can't stomach keeping a significant amount of money in a standard savings account with a low interest rate, consider a money market account that allows withdrawals only at certain minimum levels, or purchase short-term certificates of deposit with three- or six-month terms on a regular basis. You'll earn some interest and be required to constantly reinvest.
Treat it Like a Bill
Establish a monthly savings goal and make it part of your regular budget. Marquis recommends setting up an automatic monthly transfer, just as you would with the electric bill or fitness club membership, to ensure the money is saved each month.
"The forced savings should feel like a bill pay transaction that is done on the same day of every month," Smith says.
Paying yourself first through a direct deposit from your paycheck into your emergency fund account will help you build your fund steadily. But make sure you've created a balanced budget so you know you have enough money to save, says financial coach Matt Wegner of Matt Wegner Coaching in Sheboygan, Wis.
"Too many people direct deposit money in their savings accounts, only to turn around and pull the money back out to pay bills," he says. "A solid monthly spending plan can help avoid this situation."
Use it Only for Emergencies
"An emergency fund is for the unexpected," says Carrie Coghill, a Barron's Top 100 financial adviser and the director of consumer education for FreeScore.com. "For example, appliances that stop working, getting laid off from a job, a long illness or an accident. You use an emergency fund for any expense you cannot foresee."
One of the most common problems people have with emergency funds is forgetting to plan for one-time expenses each year, Coghill says.
"People budget to save and put away an emergency fund, then they forget to budget for an annual insurance expense or car expenses, etc.," she says. "You can foresee your car insurance expense next November, for example, so it is not an emergency."
One way to avoid using the fund for nonemergencies is to make access to it somewhat difficult. "Do not get access to it via debit card," Smith says. "And if you are issued a checkbook, hide it."
Take it Slow
"Rome wasn't built in a day, and neither is an emergency fund," Gallegos says. "Any action you can take to establish an emergency fund will do you good. If you transfer $10 to a savings account each week, you'll have $500 in a year."
Don't be afraid to start with a small amount of savings each month, but try to increase it whenever possible.
"When you pay off a credit card with a $50 monthly payment, increase your savings by that $50," says Gallegos. "With the same outflow you have today, you'll be paying yourself."
When you get a tax refund or commission check, add it to your fund, he says. And gradually boost your savings by selling items you don't need on eBay, holding a yard sale or putting change into a jar every evening.
"Save rather than blow your excess money," Gallegos says. "By stashing the extra, in addition to your regular predetermined amount from your budget, you'll see your savings soar."