If you learned suddenly that your home needed a new roof, could you access the cash to pay for it before your possessions were drenched? What if you lost your job? Would you be able to cover your monthly bills? You could with an emergency fund. If you don’t already have one, now is a great time to establish one.
When the unexpected happens
Everyone should have some easily accessible short-term savings stashed away. Having an emergency fund means that when the unexpected happens — whether it’s a job loss or an unanticipated home repair — you’ll have the resources to meet your day-to-day living expenses. Without an emergency fund, you may have to resort to credit cards and could find yourself paying off debt at double-digit interest rates for months or years to come. You also may be forced to sell assets such as stocks when the market is down, resulting in a loss.
One year’s worth of living expenses
While CPAs used to recommend that you set aside enough money to cover three to six months of living expenses, most of them now recommend that amount be increased to 12 months. Your individual circumstances may dictate that you have more or less. Keep in mind that this recommendation doesn’t equate to 12 months of your current salary. You just need to set aside enough to cover your basic monthly expenses.
You’ll need to determine the cost of your necessities, such as your rent or mortgage, utilities, debt repayment, groceries and life, health and auto insurance premiums. Multiply your total expenses by the number of months you want your emergency fund to cover.
It takes discipline
Building an emergency fund requires discipline. It may require reducing your spending to free up extra cash. Treat your savings as you would a bill. If you determine you need $12,000, set an affordable amount you can put away each month, without fail, until you reach your goal.
Two basic requirements
There are two basic requirements for stashing the cash in your emergency fund: (1) your money should be in a safe investment; and (2) you should be able to access it quickly. CPAs suggest using a savings account at a bank or credit union or a money market account.
Money market accounts come in two types — bank accounts and mutual funds. Both have relatively low yields with high liquidity, and both typically pay more interest or dividends than savings accounts because they are considered less transaction-oriented. It’s important to know that money market mutual funds are not insured, but since they invest in highly liquid, safe securities, they are considered relatively risk-free by most planners.
You may have to meet a minimum balance requirement to open your money market account or mutual fund, and you may be limited to only a few free checks each month. If you decide to go this route, look for a money market account or fund with a high interest or dividend rate, low fees, and check writing features. Remember your emergency fund should exist for things like unemployment, medical bills, or a new furnace — not a weekend at the beach.
Saving money on your own is seldom as much fun as spending it, but it becomes easier over time. The peace of mind that comes from knowing you have the financial resources to carry you through rough times can be worth the sacrifices you make now.
Reviewed and edited by C. William Thomas, J.E. Bush Professor of Accounting in the Hankamer School of Business at Baylor University.
Copyright, The American Institute of Certified Public Accountants