How to Build an Emergency Fund
One of the most effective tools for preventing a financial disaster is an emergency fund. This is money you set aside to cover unexpected expenses—or to keep you afloat if no income is coming in.
Even if you have a great handle on your finances, you may encounter unexpected challenges that threaten your financial stability. These include losing a job, dealing with an illness and needing to help a family member. If you’re not collecting a paycheck, or if you have out-of-the-ordinary costs to cover, this can throw your monthly budget completely off track.
The goal is to not touch the money except in a true emergency. If you have this money at the ready when you really need it, ideally it will last long enough to get you back on your feet.
Putting It Together
Ready to create your emergency fund? First, multiply your monthly take-home pay by six. This is the amount you should try to save.
It’s usually not practical or possible to create a fully funded emergency fund in one shot. Instead, plan to add to it on a regular basis until it reaches your goal. Consider making it a line item in your monthly budget, just as you would put aside a percentage of your income to add to your savings account or investment portfolio.
If you do have to dip into your emergency fund fund, it’s important to start building it back up as soon as you have the resources to do so.
Where the Money Should Be
The whole point of an emergency fund is that you’re able to get your hands on the money quickly, and without risking losing the money. For example, you might lose money if you have to sell off stocks or other investment holdings.
A standard savings account is one good place for your emergency fund. It is a straightforward way to put away money that you can access easily. An added bonus is that a balance in a savings account can reduce or even eliminate charges on your checking account. Ask your financial institution for details.
One drawback of a savings account is that it’s almost too easy to access. You’ll have to make a commitment to not touching the money, except in a true emergency.
Liquid investments, or those that you can quickly and easily turn into cash, are another good place to park the money that’s in your emergency fund. A combination of relatively short-term certificates of deposit (CDs) and U.S. treasury bills generally works well.
Ladder to Safety
If you’re using CDs as the holding place for your emergency fund, one smart approach is a technique called laddering. Instead of putting a large sum into a single CD with a specific term, you split your principal into three or more CDs that mature in steps, perhaps every six months over an 18-month period.
Each time a CD matures, you can roll it over for another year so the ladder continues. That means you have a lump sum available every six months in case you need the cash, and you won’t have to pay any penalties.
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