Even if you have a great handle on your finances, unexpected challenges such as losing a job, dealing with an injury or illness, or having to help a family member in need can threaten your financial stability. It doesn’t take much to throw your monthly budget off track.
One of the most effective tools for preventing a large-scale financial disaster is an emergency fund. This is an amount of money set aside to cover unexpected expenses. It can also be used to keep you afloat if you have to take leave from work and no regular income is coming in.
The goal is not to touch that money except in a real emergency. If you have it at the ready when you really need it, you’ll avoid the kind of financial disaster that has repercussions lasting years or even decades.
Putting It Together
To create your emergency fund, multiply your monthly take-home pay times six—that’s the amount you should aim for.
It’s usually not practical or even possible to create a fully funded emergency fund in one shot. Instead, plan to add to it on a regular basis, in an amount you can reasonably afford, until you reach your goal. You might consider adding an emergency fund as a line item in your monthly budget, just as you do when you put a percentage of your income toward a savings account or an investment portfolio.
If you do have to dip into the fund, it’s important to start building it back up as soon as you have the resources to do so.
Where to Put the Money
The whole point of an emergency fund is that you’re able to access the money quickly, without any risk of losing money by using those funds. (That might be the case if you had to sell off stocks or other investment holdings.)
A standard savings account makes sense as a place for your emergency funds. It is a straightforward way to put away money that you can easily withdraw when you need to. The one drawback with a savings account is that it is almost too easy to access. You’ll have to make a commitment to not touch the money except in a true emergency.
You might also look into liquid investments, or those investments that you can turn quickly and easily into cash. A combination of relatively short-term certificates of deposit (CDs) and U.S. treasury bills could work quite well.
If you do decide to use CDs as the holding place for your emergency fund, one smart approach is to use a technique known as 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 a stepped pattern—perhaps every six months over an 18-month period. Every time a CD matures, you roll it over for another year so the ladder continues. That means that you have a lump sum available every six months if you need the cash, without having to pay any penalties.
And very importantly, be aware that if an emergency occurs and you do have to dip into the fund, it’s important to start building that money back up as soon as you have the resources to do so.
Mascoma Bank offers a wealth of articles, lessons, and quizzes on financial literacy through a partnership with Banzai Inc, a leading financial educator. Take a look!