Disasters come in many forms: earthquakes, fires and hurricanes are a few. But on the personal level, few events can be as frightening as a massive, unexpected financial calamity.
Whether it’s the expense of a medical emergency or a flood in your living room from a burst pipe, sudden money troubles can undermine even the most sensible planning. To cope with those problems, and even less dramatic ones, it’s a good idea to maintain an emergency fund.
An emergency fund is money set aside exclusively to cover the cost of surprise events such as a job loss or major car troubles, usually in an account that can be accessed with few, if any, withdrawal penalties. It should be part of every family’s financial plan, and should be thought through long before the money it contains is needed.
An emergency fund offers peace of mind when times are good and can defend against financial ruin if things turn bad.
Americans aren’t great savers. A recent study on savings habits suggests most don’t have a reserve large enough to cover a $500 car repair. According to the federal Commerce Department, the personal saving rate in mid-2016 hovered around 5.5 percent of income – higher than it was in the early years of the 21st century, but lower than earlier decades. In mid-1975, the rate was 17 percent.
An emergency fund is all about saving. It is a personal safety net with a hidden advantage – it gets people in the habit of socking away money, which is also an essential component of retirement planning.
A well-conceived emergency fund can safeguard against the need for high interest loans from payday lenders and credit cards. Millions of Americans live paycheck to paycheck, a strategy that puts them forever in peril. An emergency fund is like the lifeboat on a ship, waiting and ready if catastrophe happens.
Consider other steps to take:
Then you need to decide where you’ll keep the money. Forget the shoeboxes and mattresses and open a savings account. Consider a bank or credit union where you have a checking account, since many institutions offer lower fees and free checking to those who have large enough savings balances. If you have a cash-card, avoid having it linked to the savings account. The idea is to make it difficult to draw on the account in a moment of weakness.
Make sure you open a new account specifically for the emergency fund. Commingling the money with your spending account is too tempting. You should look at the savings account options – money-market accounts generally pay more interest than conventional savings accounts. You also might consider a short-term certificate of deposit, but remember any CD limits the liquidity of the funds.
Also, don’t invest your emergency fund in stocks, bonds, ETFs or mutual funds. Though these are great instruments for long-term capital growth, their value will fluctuate with the financial markets. If you need funds for an emergency, you don’t want have to sell stock in a depressed market.
You should create a system for making routine, timely contributions to the emergency-fund account. Consider automating your savings. Use direct deposit, or create an automatic transfer from your checking account. Also consider adding any windfalls you might receive to the fund. Tax refunds, gifts from relatives and inheritances can be deposited, but it’s up to you to resist the temptation to spend the money right away.
Absent a windfall, remember that it takes time and discipline to build a fund. Scheduled deposits are the best route to success, and the size of deposits should be determined by what you afford. Fight any urge you might have to tap the fund for predictable expenses like car insurance or property tax. These expenses should be part of your family budget and separate from your fund.
Emergency funds might require self-restraint, but being prepared for the unexpected will add a sense of calm to your life .