Building An Emergency Fund

By Investopedia Staff AAA

Unlike the luxuries that so many of us purchase with our credit cards, having an emergency fund is a necessity. Financial experts recommend that people maintain a cash reserve large enough to cover three to six months' worth of household expenses. Rest assured, someday you will need it. To quote the American poet Henry Wadsworth Longfellow, "Into each life some rain must fall, Some days must be dark and dreary." Perhaps the person who coined the expression, "save for a rainy day" had Longfellow's words in mind, when he or she spouted those often repeated, and often ignored, words of wisdom. Here we look at how much you'll need to save for your emergency fund and how you can get started, today.

Tutorial: Introduction To Banking And Saving

What Will You Need?
An emergency fund is a great idea, but it also requires some effort to achieve. The first step in the process is to figure out how much you spend each month. Consumer expenditure statistics from the U.S. Department of Labor indicate that the average annual expenditure per consumer unit, which is similar to a household, is $48,109, as of 2010 (the most recent year for which data is available). This data is broken down by month in the table below. The months in bold highlight the cumulative quarterly expenses, and therefore, the recommended cash reserve for the average household.

Number of Months Cumulative Expenses
1 $4,009.08
2 $8,018.17
3 $12,027.24
4 $16,036.32
5 $20,045.40
6 $24,054.48

Source:http://www.bls.gov/news.release/cesan.nr0.htm

While your household expenses may be higher or lower than the average, there's no doubt that even three months' worth of expenses is a big number. One look at that number and the average person's first reaction is, "I can't come up with that kind of money."

Why So Much?
The amount of money required to fund a proper emergency fund is certainly significant, but we live in uncertain times with uncertain economies. Corporate loyalty is a thing of the past and unemployment can happen unexpectedly, usually at the worst possible moment. Likewise, emergencies like sudden illness or disability, car repairs or a new roof, can be expensive and there's never a "good" time for these things to happen.

While it's probably true that you don't have an extra $12,027 lying around, everything is relative. Even six months' worth of expenses is a puny number compared to the amount you will need to save for retirement; there's not a savvy investor out there, who balks at the idea of stashing away so much money that he or she will never need to work again. When compared to what you'll need over the course of 20 years in retirement, three months' worth of expenses doesn't look like much. (For more on retirement savings see How To Maximize Your Retirement Income).

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Watch: Building An Emergency Fund

Crunching the Numbers
Now that you have things in perspective, it's time to start saving. Approach this effort the same way you would approach any other financial goal. Put together a plan and execute it. The first step, is to determine how much you spend each month. Housing, transportation and food will likely be the three categories that eat up most of your cash. The average U.S. consumer spends 65% of his or her income on these items. Once you know your total expenses for each month, multiply that number by three. Reaching that number will be your initial goal. To achieve your three-month target, you need to start saving money. (To find out where your money is going, see The Hidden Costs of Home Ownership).

If we assume your initial goal is $10,000, the table below illustrates how much you will need to save each month, over a five-year or a 2.5-year period.

5-Year Plan Amount Needed per Month 2.5-Year Plan Amount Needed per Month
60 months $166.67 30 months $333.33

Putting Your Plan into Action
Buying a less expensive car, the next time you are shopping for a vehicle and canceling your cell phone service, are two easy ways to come up with some cash to fund your savings plan. Skipping that two-week vacation, cutting down on the amount you spend dining out, and saving your next raise or bonus, are also simple methods of adding to your emergency fund.

Ideally, you should treat your emergency fund like any other recurring bill, that you must pay each month. Dedicate the appropriate amount from your paycheck and set it aside. While most people have no qualms about sending enormous amounts of money to credit card companies, on a regular and systematic basis, they balk at the idea of paying themselves, first. Change that equation; cut up your credit cards and put those payments into your emergency fund.

If you are among the many investors who don't have a "rainy day" fund stashed away in case of emergencies, there's no time like the present to start saving, even if you don't have the dedication to address the project with a dedicated savings program. You can start simple, by taking the change out of your pockets at the end of the day and putting it in a jar. You could also eat at home instead of dining out and "tip" yourself by adding a few bucks to your emergency fund. If you get "cash back" on your credit cards, or just paid off a big debt, such as a personal loan or an automobile, put that newfound money into your fund. If you get a tax refund, deposit the check into your fund. If you manage to dedicate just $5 per day to your effort (less than the cost of lunch!), you'll have $1,825 at the end of the year; that's $9,125 in just five years. (For more money saving ideas, read Top 5 Easy Saving Tips)

The Bottom Line
You need to view your emergency fund like an insurance policy and once you have it, guard it carefully. It's not a piggy bank; you should not be dipping into it for incidental expenses. Use it only in the event of an emergency, and hope that an emergency never happens. Remember, once that money is spent, the time it takes to replace it is always much longer than anticipated. Start now and save whatever you can, even if it isn't much. Some day, when you need the money, you'll be glad you did. (For more personal finance tips, see Seven Common Financial Mistakes and The Indiana Jones Guide To Getting Ahead.)

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