Every family needs a financial safety net for unexpected expenses. Here's how to set one up.
Aubrey Cichelli knew about the importance of saving for a rainy day—but knowing and doing are two different things. Cichelli and her husband lived within their means but hadn't created a cash cushion to fall back on in case of something unexpected. For them, the crunch came five months ago in the form of a pink plus-sign on a pregnancy test.
The Salt Lake City couple already has a 15-month-old son. "We're thrilled about the new baby, but the timing is a bit of a surprise," admits Cichelli. "We recently bought a house, and I just started a new job—one that doesn't offer paid maternity leave." Now Cichelli and her husband are saving every cent they can—and working hard to figure out how they'll make ends meet.
Unfortunately, many families could find themselves in a similar financial situation. While 71 percent of Americans believe it's very important to have an emergency fund, only 44 percent actually maintain one, according to a survey by Bankrate.com. And plenty of people aren't prepared for a cash crunch—a poll by HSBC Bank found that 40 percent of Americans have saved just one month or less of basic living expenses. But experts say you should have three to six months of your living costs set aside. While that sounds overwhelming, you owe your family the peace of mind this financial cushion provides.
To get started, examine your budget to figure out how much you'd need to live for three to six months without a paycheck. Make a list of necessities—mortgage, food, insurance payments, and other fixed expenses. Then, list money that goes to things like entertainment and gifts. This helps you figure out how much your emergency fund should include—as well as ways to cut back on spending. A computer program like Quicken can be helpful in creating a household budget.
If you're starting a fund from scratch, set up a standard savings account since the minimum required balance is low. Keep your emergency account separate from your savings account, and forgo the bank's offer of checks or an ATM card. "That way, you won't be tempted to dip into it," says Eric Gelb, an accountant in St. Peters, Missouri. Another smart move: Have your employer divert part of your paycheck into the account so you won't even see the cash.
When your fund reaches $1,000, move the money to a savings vehicle where it can earn a higher rate of interest. But make sure the funds are liquid—that you can draw on them quickly, easily, and without paying fees or penalties. Woodbridge, Connecticut-based financial planner Alan Weiss says that two good options are money-market funds or short-term CDs, which mature after three or six months. Avoid putting emergency savings into individual stocks, treasury bills, or mutual funds. "Think low-risk," Gelb says. "Protect this money so it's available when you need it."
Definite don'ts for building a rainy-day fund? Don't take a loan from your 401(k); if you lose your job, you have to repay the loan fast or pay penalties. The same goes for borrowing from an IRA; that needs to be paid back quickly too.
Bottom line: Building an emergency fund takes discipline and sacrifice, but the payoff is worthwhile. You get the peace of mind that comes from knowing you're financially prepared for whatever might come your way.
Easy Ways to Save
Here are five things to cut from your budget:
- Cable channels. You can always reorder them when your fund is in place.
- Phone plans. Consider getting rid of your home phone line, if you still have one.
- Gifts. Make a pact with friends and family to give only homemade holiday and birthday gifts for a year, or set a spending limit.
- Entertainment. Visit the library for books and videos. "Lose" your collection of takeout menus for a while too.
- Bad banking behavior. Do you use ATMs that charge a fee? Rack up late charges on bills? Pay a high interest rate on credit cards? Quit these bad habits now. If you must use credit, get a card that gives you cash back at stores where you shop often.
Sometimes the situations that send us into a tailspin aren't real emergencies—but they still put a big dent in our bank account. Do you have the savings to cover these not-so-rare occurrences?
- Insurance deductible in case of a car accident: $500 to $2,000 or more, depending on your plan
- Four new tires: $500
- New hot-water heater: $500
- Root canal, without dental insurance: Up to $1,200 per molar
- Exterminator fee: $250
- A trip to the emergency room: $500