Expecting the Unexpected: The Importance of an Emergency Fund

EmergencyFundIf you suddenly became ill or your car seriously broke down, would you be able to dip into savings to foot an unexpected $1,000 bill? If you are like one in four Americans, you would have to borrow from a friend, stop paying other bills, take out a loan, get a cash advance from your credit card, or pawn your belongings to make ends meet. Now imagine that you suddenly lost your job and had to use your savings to cover living expenses. Would you be able to cope?

A 2011 Bankrate poll found that less than half of Americans have enough money set aside to cover three months of living expenses. With chronic unemployment troubling people from all income brackets, many industry experts now recommend keeping an emergency reserve fund that covers at least six months of living expenses. Just 24% of Americans have a six-month emergency fund. Most of those who do are in their 50s and 60s and come from a higher-income household.

If you don’t have any emergency savings set aside or you haven’t saved enough, it’s easy to start today. Although it may take months to build up your emergency fund to the level you need, it is an essential step on your road to financial health.

Begin by calculating your fixed monthly expenses. These expenses include your rent or mortgage, car payment, property taxes, insurance, child care, and any other regular expense that does not vary from month to month. Next, calculate the average amount you spend on variable expenses such as groceries, eating out, clothing, entertainment, and utilities. Add your fixed and variable monthly expenses to determine how much money you need for a three-month emergency fund.

Once you know how much money you need, it’s time to start building your emergency fund. The key to successful saving is to pay yourself first. Many people pay their bills, buy groceries, go back-to-school shopping and then find that they don’t have any money left over. Instead, set aside a small amount of money from each paycheck before you pay your other expenses. Paying yourself first ensures that you make your savings a priority. Starting with $10 or $25 per paycheck is a great way to get into the habit of saving without breaking the bank. As your emergency fund begins to grow, you can increase your rate of saving to $50 or more per paycheck.

If you are living on a tight budget and even $10 per paycheck seems like too much, look at your variable expenses to find ways to cut back. Perhaps you take your family to the movies once per month. Instead of buying expensive tickets and movie theater popcorn, rent a movie at home and make your own snacks. Or go to a budget movie theater to catch an older release for half the price. Cutting back to save small amounts of money translates to greater financial security as you build your emergency fund.

Now that you have some money saved, where should you keep it? It’s unwise to risk your emergency fund in the volatile stock market, but it is important to earn some interest on your savings. Consider putting your money in a high yield savings account or purchasing a certificate of deposit to earn compound interest on your savings. Little by little, you can improve your financial security and prepare for the unexpected.