Even those who are the most careful with their budgets will have to deal with the unexpected from time to time. Occasionally financial events outside of your control, which threaten to throw your normal monthly budget completely out of whack, will arise. To be prepared for such events, you need to build up an emergency fund.
What is an Emergency Fund?
An emergency fund is a store of money that you have available to help you handle unexpected and unavoidable events. Some examples include:
- Losing your job
- Missing work due to illness
- Medical expenses
- Essential home repairs
- Serious car trouble
You get the idea--the key words here are "unexpected" and "unavoidable." The above are emergencies, but a great deal on the car you've been eyeing is not an example of an emergency.
Using an emergency fund in these cases would be less costly than alternatives such as going into debt, dipping into a 401(k) or IRA, or selling long-term investments at the wrong time. The answer then, is to build up a pool of savings equivalent to roughly six months of expenses, and reserved for emergency use only.
Saving for an Emergency Fund
Building an emergency fund may challenge a savings rate that is already struggling to set money aside for retirement or other long-term needs. However, here are three possibilities for building up the necessary savings:
- Go on a temporary "emergency" budget. Try living for a while with some extra sacrifices--these are likely to be less painful than the sacrifices you'd have to make if you ran into trouble without having an emergency fund
- Split savings between your retirement nest egg and the emergency fund. Saving for the emergency fund should be temporary, so you can resume full retirement savings once the emergency savings are built up
- Use a windfall. Using part of a bonus from work or a gift from a relative is a good way to jump-start your emergency fund
What to Do with Your Emergency Fund
An emergency fund must be readily available, so a savings account is the natural solution. You might also consider a certificate of deposit (CD) because longer-term CD rates will generally be higher than savings account interest rates. However, there could be a penalty for early withdrawal, so this depends on how much better the CD rate is, what the penalty would be, and what you think the likelihood of encountering an emergency is.
Whether you choose a CD or a savings account, be sure to shop for a competitive bank rate. Just because that money is waiting for an emergency doesn't mean it shouldn't be earning some interest in the meantime.