How to Develop a Great Emergency Fund

Here are some thoughts on developing a great emergency fund from financial expert David Bach. He lists four steps to doing this. They are:

1. Make your rainy day fund automatic.

2. Get your emergency money out of your checking account.

3. Put it in the right place.

4. Decide how big a cushion you need.

He then suggests places to look to get the highest interest rates possible including:

• Look online. (ING Direct and EmigrantDirect)
• Go to your bank.
• Invest automatically with government savings bond.

A few thoughts here:

1. We keep our emergency fund money in a Vanguard money market fund. It earns a bit less than ING and ED, but means we have to manage one less account and it's easy to get money into and out of (and dollar cost average with Vanguard mutual funds).

2. We have six months worth of living expenses saved. I prefer to be conservative -- so I go for six versus three months.

3. Our emergency fund is fully funded now, so we don't have to make it automatic. But it was automatic when while we were accumulating it.

4. You must, must, must have an emergency fund. If you don't, then any financial emergency (and these will pop up for all of us) will force you into debt. Start saving today -- even if it's just $20 a month. Start small and work up if you have to. If you keep with it, you'll have a good amount saved in a very short amount of time.

Comments

[King of Debt]

We just added an automatic savings to our emergency fund into our buget. And although it is not a large amount it certainly feels better that we are moving in the right direction.

[Kimber]

Totally agree that one needs a source of funds for emergency.
Many people have an unused HELOC for this purpose.
I prefer to have both the HELOC and the emergency cash.
The emergency cash I sometimes dip into when I run across "expiring" investments but I do repay it.

[Dan]

Question for those of you who do emergency funds. The benchmark is always 3-6 months of living expenses. But do you save for 3-6 months of your full budget, or do you assume that in an emergency (job loss) you would cut back on certain things, meaning your budget during that crisis would be smaller and thus you need to maintain less emergency savings?

We take this tactic. I've split our budget into needs and wants and we're saving for six months of our "needs" budget. For example, the house payment is a need. Retirement savings is a need. 75% of our food budget is a need; we figure we can trim that down a bit in an emergency. Only 25% of our clothes budget is a need. Cable TV and most of our weekly spending cash and entertainment money are wants that could be cut in an emergency.

Does that make sense? Anyone else do this? Anyone else see any negatives to this approach?

[ib]

dan,
i did that too. i don't have what i would make in that amount of time, but rather, what could i possibly squeak by with. i would buy nothing but food and pay for rent and utils and probably not much else (if i could help it) if i had lost my job or similar event. in an emergency i wouldn't be using nearly as much $ and sad to say, i would not be putting any more $ into my roth for instance, because, well i would have to eat now, wouldn't i? short term becomes far more important for the time being until income (or more subsisting income) resumes.

[Foobarista]

My take on the "expenses" thing: if you've got cable TV, cutting it off will only cause additional strain in an already strained household, especially if you have kids. There are some other "wants" that are in this category: go camping in the nearby state park instead of flying to Disneyworld for vacation - versus no vacation - etc. If you have to do so, then do it, but I wouldn't _plan_ to do this.

As for the e-fund, we have a short-term and longer-term e-fund. The short-term money is for stuff like car expenses and such, and is in a savings account at our credit union paying 4.85%. The unemployment and big expenses fund is in I-bonds, and we have about a year of expenses in it.

[Mike]

I doubt that a HELOC is a good emergency fund. At least, don't make the mistake of letting on that you've lost your job when you visit the bank to tap it. Read about someone who did that and his HELOC ended up being pulled when he needed it. Liquid funds are best. I also have US Savings bonds, including some I-bonds I bought in 2000 that pay 3.5% plus the inflation adjustment. My theory is that in an emergency such as a job loss I'll be in a lower tax bracket, so the income tax on the interest that's deferred until I cash it will be less than the taxes I'd pay year by year on a deposit account. Disadvantage is that you can't cash savings bonds for the first year, so you need to have funds built up in a demand deposit account before you gradually start building up savings bonds.

Of course, before you can build up an emergency fund you have to get your spending under control. If your spending control is whatever's in your checking account, or even worse the remaining balance of your credit card limit, then you can forget about building up an emergency fund. Or have to run ploys where you hide money from yourself such as in another account. This can work, but the best approach is to control your spending with a budget. That's my approach, and I keep a comfortable balance in my checking account so I don't have to keep an eagle eye on my checking account day to day.

Being a single man, I've been able to live well below my means and currently have an emergency fund to cover 2 years of expenses. That doesn't include continuing retirement contributions, however. While I have above the median retirement savings for my age, when the crunch comes you have to eat that day.