The Importance of an Emergency Fund

Having an adequate emergency fund is more important than ever these days. Here's how you can prepare for those inevitable financial surprises.

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When you face a financial emergency, like an auto repair or unexpected medical bill, how do you pay for it? If you’re like many Americans, you don’t have the cash on hand, so you pull out your credit card and worry about paying the balance another day. Unfortunately, some people don’t have access to credit, or can’t make new charges because of maxed out balances. Desperate, many of these people are forced to rely on expensive payday loans or cash advances. But, there’s another way.

The Benefit of Having Emergency Funds

Imagine having a reserve of cash you could use to cover an emergency. You wouldn’t have to borrow from next week’s paycheck nor would you have to put the balance on a credit card with a high interest rate. You’d pull from your savings and you wouldn’t be left owing anything to anyone. That savings isn’t a foreign concept; it’s called an emergency fund.

The ideal emergency fund is large enough to cover three to six months of living expenses. That way, if you lose your job, you’d have enough money to pay your bills for up to six months while you look for another job. If you’re a contractor, are self-employed, or have a volatile job, you might build a year’s worth of living expenses into your emergency fund.

As it was indicated earlier, an emergency fund does more than bridge the gap in your income. It serves as a safety net that can catch you when unexpected expenses arise. If you have an automobile accident, your car insurance company will require you to pay a deductible before it pays for any expenses. If you run out of contact lenses, you’ll have to buy some new ones so you can see. We are constantly presented with these monetary
challenges.

What Happens When You Don’t Have One

Not having emergency funds is risky. If a financial emergency came up today, let’s say to the tune of $1,000, how would you pay for it? If you use money you currently have in your checking account, you risk missing some of your other bills. When that happens you face late payments and even service interruption on things like electricity and water. You could put the expense on your credit card, but that could prove expensive considering the finance
charges. You could borrow it, but could you really afford to pay it back with your next paycheck?

How to Build and Use Your Emergency Fund

An emergency fund should be spent on things you need, not things you simply want. For example, you shouldn’t spend your emergency fund on a vacation, a new television, new home furnishings, or the latest Blackberry. Instead, you should only spend your emergency fund on true emergencies.

To deal with the temptation of spending your emergency fund, you should keep it separate from your regular checking and savings accounts. In fact, putting your fund into an online savings account, like the one from ING Direct, is good. That way, the money is far enough away that you can’t get to it immediately, but close enough to access in a critical situation.

If you’re like most people, you don’t have three to six months of living expenses lying around. So building your emergency fund will take time. That’s perfectly fine. It’s a good idea to go quickly stash away $1,000 but continue contributing to it until your emergency fund grows to its ideal level. That way you have a small cushion to use while your emergency fund is in construction mode.

When you break that bank and pull from your emergency fund, be sure to replace what you’ve used so you always have the right amount of funds available. As your lifestyle changes, i.e. your living expenses increase; check your emergency fund level to make sure it matches what you’d need in an emergency.