An Emergency Fund: Your First Line Of Defense

Downsizing, rightsizing, forced retirement, layoffs,
firings, outsourcing, and being made redundant.

All could mean the same thing to you: financial catastrophe.

No, you may not have to declare bankruptcy or move back in
with your parents, but losing your job could put a big dent
in your financial goals and even set you back several years.
You may need to live on your savings or liquidate some of
your investments.

If you have no savings or investments you may have to rely
on credit cards and could rack up significant credit card
debt. Then when you find a new job, your expenses may have
increased because of the additional credit card payments.

And the job you eventually find may not pay as much as the
one you lost. So you are now forced to live on less while
your expenses have either continued at the same level or
even gone up.

Studies show that the average worker will have six career
changes in his or her lifetime. Not just job changes, but
career changes.

So how can you prepare for your own financial "downtime"?

An emergency fund.

An emergency fund is really just savings. But it is not
savings for a particular item or even an investment for your
future or your retirement. It is your "rainy-day" fund.
But unlike insurance where once you pay your premium, the
money is out of your hands, your emergency fund is yours to
keep.

So how much do you need? How can you build your emergency
fund? And where should you keep the money?

The easiest way to figure out how large your emergency fund
should be is to take your current income and multiply it by
the number of months you could be out of work. If you make
$3,000 each month and you want to be prepared for a 6 month
"vacation", you will need $18,000.

But obviously saving $18,000 will take some time. How
quickly you want to build your emergency fund depends on how
concerned you may be about your current and future
employment prospects.

Saving $100 each month will take you 180 months or 15 years.
Saving more each month means you will be protected sooner.
Also consider that during the next 15 years your income may
increase and your expenses usually rise to match your
income.

Also consider inflation. (If you own your home, your house
payment may not rise. If you are renting, your rent
probably will.) The cost of food, utilities and taxes also
rise over the years. At a 3% inflation rate after 15 years
your $18,000 will only buy $11,400 worth of goods.

A good rule of thumb for saving is to try to save enough
each year to supply you with one month's income. This means
you are saving 1/12 or 8.3% of your monthly income.

This will allow you to build your emergency fund by one
month every year. After only six years you will have a
six-month supply of emergency cash. Then you can continue
to extend your "coverage-period" or you can divert the
monthly payment into other savings or investments.

Most people find that "billing" themselves for savings and
investments is a good way to put your savings on auto-pilot.
If an amount is taken automatically from your bank account
each month, it is easier to handle than if you wait until
the end of the month and try to save from what you have left
over. (How often do you have anything left over?)

So where is the best place to keep your emergency fund?
Probably not a place where you can have easy access to it -
too tempting. Definitely not as cash in the cookie jar -
too unsafe (and no interest). And probably not in 5 year
CDs - too restrictive. You may want to avoid CDs altogether
so that you are not charged an early withdrawal penalty when
you can least afford it.

Savings accounts are OK, but usually pay very little
interest. If a savings account is your choice, open one at
a bank that you don't regularly use. Also don't get a
checking account to avoid the temptation to spend "just a
little" bit here and there.

Or look for a money market account that pays a reasonable
interest rate. You may want to consider a money market
account that only invests in tax-free securities. This way
you won't have to worry about paying taxes on your interest.

Then set up an auto-withdrawal from your regular checking
account or direct deposit amount from your pay check right
into this new account. Adjust your budget to accommodate
having less money each month and forget about it.

You can also give your emergency fund a boost now and then
by putting "windfall" money into to it. You know
"free-money"; birthday gifts, inheritances, insurance
settlements, escrow overages, rebates, tax refunds, etc.

Your emergency fund becomes your own financial insurance
policy. And if you never use it you will have that much
more money to play with when you retire. Or even retire
early with the extra money you have saved.