Emergency Fund

Most financial planners agree that having an emergency fund for a rainy day is the first step in a sound financial plan. “If there is one thing financially that will help you sleep better at night, it’s the knowledge that you have some money in the bank for a rainy day,” says Bankrate’s Senior Financial Analyst Greg McBride. Here is an article from Bankrate.com about the importance of having an emergency fund all the time.

A lot of financial difficulties can be traced back to a few common root causes, according to McBride, and one of these is lack of emergency savings. For that reason you need to plan for the unexpected, whether for a dental bill or job loss.

Why you need it

Up until now you may have relied on home equity or credit cards for unplanned expenses or emergencies. If you tap home equity, you generally incur more debt (at least until you sell your home). If you use credit cards, you are committing future earnings to current spending. Neither of these is a desirable financial solution. A savings account empowers you to use your own funds to meet financial challenges. And when you’re not using the funds, the bank pays you interest.

McBride suggests keeping emergency funds in a high-yielding money market or savings account so that the money generates a tangible return in the form of interest.

“These types of accounts are going to get a lot more attention now,” says McBride. “There’s finally a bit of a premium to be had on longer term investments.” He suggests that once you have six months of expenses in a savings account, boost your return a little bit by taking half of that and investing in a three-month CD or a short term bond fund while keeping the other half in a liquid money market or savings account.

Savings guidelines

The rule of thumb is to save three to six months of living expenses — more if you’re self-employed or the sole breadwinner. But the key is to have a system of automatic savings that can replenish the account in case you dip into it. Although three to six months is the ideal cushion, it’s going to take quite some time to get to that level.

Figure out your monthly living expenses with this work sheet. Work out how long it’ll take you to get there with Bankrate’s simple savings calculator.

Getting started

The biggest obstacle to saving is not being in the habit of doing so. So take steps to pay yourself first. Set up direct deposit from your paycheck to a high-yield savings or money market account. This accomplishes two things, says McBride: It works toward building a savings cushion and forces you to live on less than you make.

“Those are really two key steps on the road to financial security: saving regularly and living within your means,” he says.

Even in the presence of debt, contributing to an emergency savings account takes top priority, but not at the exclusion of working toward other goals. “It’s the habit of regular saving that has to be instilled, even if it’s $25,” says McBride. “The money you get from trimming expenses or working a second job can be used for aggressively paying down credit card debt.”

A benefit of working toward multiple goals simultaneously is that if you’re building savings while paying down credit cards, you have some savings in place that should absorb an unexpected expense. This reinforces the need to have that savings and doesn’t negate your debt repayment efforts.

For handling the larger expected bills looming on the horizon — say, property taxes — you have a few equally good choices, says McBride.

Select the plan you prefer:

1) Include extra savings to your emergency savings account.
2) Create a separate side savings account with the express purpose of meeting your tax bill.
3) Incorporate the added savings into your regular monthly budget so that while you may only pay taxes or insurance once a year, you are effectively breaking the bill into 12 smaller chunks.

Where the money lives is up to you. Whether you keep it in a checking account so you can just write a check when the bill comes due or move the money to a high yield account for the interim, the discipline is to set that money aside so it’s there when you need it.

“In the end,” says McBride, “there’s no substitute for good, old-fashioned discipline. That emergency savings account isn’t something to tap for pizza on Friday night.”

(Source: Bankrate.com)