Back in January 2014, Time reported that 44 percent of Americans are living paycheck-to-paycheck. That means that nearly half of all Americans don’t have the financial cushion to handle a job loss, a major illness, a natural disaster, or some other unforeseen expense. If you approach the end of every month by holding your breath, crossing your fingers and praying for no unexpected expenses, this may be the right time to start an emergency fund.
What is an emergency fund?
An emergency fund is money you set aside to cover one of two scenarios: a drop in your income (like losing your job), or an expense you can’t avoid. That could include car repairs, an insurance deductible, travel expenses due to a family emergency, etc. (Replacing a broken TV does not count as an emergency.) While financial advisors used to suggest that everyone set aside three months’ salary, they’re now saying that six months’ salary is safer and more realistic. Whatever amount you choose to save, what you do with it is equally important. Good emergency funds have several related characteristics in common:
Since you’re only supposed to access the money in a true emergency, it makes sense that it would be something you can get to quickly – after all, emergencies don’t limit themselves to banking hours. If you can access your account online, you can always do a wire transfer to your regular account; there are, however, fees associated with that. A better option, if you have enough self-control, is an account with a debit card and/or checks.
Liquidity is similar to accessibility. It refers to how long it takes to convert funds to cash. While investing in CDs, mutual funds, or bonds might bring you a higher return, it can take a while to convert those accounts to cash. A safer idea is an interest-paying savings account. It won’t pay much, but you’ll be able to use the cash if you need it.
Risk refers to the likelihood that, at the moment you need to sell it, your investment will be worth less than you put in. That could happen, for instance, if you invested your emergency fund in a stock and the stock price dropped. Once again, savings accounts come out ahead here. Just be sure to read the Terms of Service and that you understand all of the particulars.
How do you get started?
You may be thinking, “That makes a lot of sense, but how do I find room in my budget?” Here are some tips.
Make it invisible
It’s easier to save if you never see the money. Find out whether your employer has an automatic savings plan where they just take the money out of your paycheck. If not, you can set up an automatic transfer with your bank so that they move a specified amount from your checking account to your savings account on a regular basis.
Crank it up a notch
Once you’re used to your smaller paycheck, raise the amount you transfer to savings each month. Even if it’s only an extra $5 or $10, it adds up.
Take advantage of windfalls
Any “extra” income should go straight into your emergency fund. Common sources of “windfalls” are employee bonuses and tax refunds. In addition, some higher-paid Americans (who may still be living paycheck-to-paycheck) max out on their Social Security contributions at some point during the year. From that date until January 1st, they’ll see a substantial increase in their take-home pay. If you’re fortunate enough to meet that hurdle (the dollar amount changes yearly), put the additional money from each check into your emergency fund. This will also cushion the blow when your cheque drops back down to the normal amount in January. Do the same thing if you pay off a debt. Put the amount you were paying toward that debt into your emergency fund.
These suggestions should help you choose an emergency fund strategy and get started putting money into it. But there’s one more thing you need to know: when to quit. When you’ve reached your goal – a six-month cushion, for instance – start putting your “emergency fund donation” into a higher-yield account, like a mutual fund. If you need it, you’ll have time to liquidate in a way that makes sense instead of panicking.
Do you have an emergency fund? What tips do you have to share?
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