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Building an emergency fund

By Richard Barrington | MoneyRates.com Senior Financial Analyst, CFA

emergency fund

Sooner or later, there will be an unforeseen demand for your money. Building an emergency fund can help you cope with these types of demands without going into debt or missing your obligations.

Beyond just helping you through a short-term crisis, an emergency fund can also become a building block for good financial habits that will contribute to your wealth throughout your life. This guide will take you through some of the reasons for having an emergency fund, how you can build one and how you might invest the money.

Why do you need an emergency fund?

When Americans are short of cash, they tend to reach for their credit cards. This may be a convenience, but it can be an expensive way of dealing with a financial emergency. Even at a time when mortgage rates had dipped below 4 percent, average credit card rates were still around 13 percent -- and considerably higher for people with limited or damaged credit histories.

Having a ready reserve of money can help you deal with the unexpected without taking on credit card debt that could substantially escalate the cost of the crisis. Here are some examples of when you might need this type of reserve:

  1. Car trouble. From a flat tire to a blown transmission, the cost of car repairs can easily be a shock to the average person's budget.
  2. Medical bills. Even with health insurance, co-pays and other payments within your deductible can get quite pricey, and some treatments are not covered at all.
  3. Essential equipment. You need to be disciplined about what you consider essential -- for example, your iPod or video-game console should not really make the cut -- but items like your smartphone or laptop might be necessary for doing your job or looking for work. Thus, if they go down, you need to be able to replace them promptly.
  4. Job loss. Even if your expenses are comfortably within your budget, losing your job can make it impossible to make ends meet without a cash reserve to help you get by until you are back to work.

How much should be in your emergency fund?

When you start to think about how much the above items could cost, chances are good that losing your job will be the most expensive. According to the Bureau of Labor Statistics, the median period of unemployment was running at 13 weeks as of the end of 2014, but it peaked at nearly 26 weeks in the aftermath of the Great Recession.

So, if typical periods of unemployment have been between three and six months in recent years, you should aim to have enough to cover essential expenses for a similar period in your emergency fund. Here are some tips for building your savings:

  1. Cost cutting. Take a look at your expenses, and see where you might be able to cut back. Think in terms of what discretionary items you might have to do without entirely if you lost your job, and reduce those expenditures at least to some degree to help you prepare for an emergency.
  2. Bank your raise. The easiest time to save money is when you just got a raise. Put some portion of that raise toward savings from the start and you will never miss it.
  3. Keep up the good work! Once you have built up an adequate emergency fund, don't stop saving. The budgeting and saving habits you develop in accumulating your emergency fund can help you save for longer-term goals, such as buying a house or funding retirement.

How should you invest your emergency fund?

As your emergency savings build up, you need to make sure it is invested responsibly and that you can access it quickly when needed. Here are some suggestions:

  1. Savings and money market accounts. These are safe and immediately liquid, and although savings and money market rates are usually the lowest bank rates, you can do a little better if you shop across several banks. (If you don't want to shop for rates in person, you can compare savings account rates and money market account rates from hundreds of banks on MoneyRates.com.)
  2. A cash cushion in your checking account. When savings and money market rates are low, consider keeping a portion of your emergency fund in checking so your balance can qualify you for a fee waiver.
  3. Certificates of deposit. Longer-term CD rates are typically higher than savings and money market rates, and even though there is a penalty for early withdrawal, assuming you don't have an emergency every year, you could come out ahead keeping at least a portion of your emergency fund in a CD.

Finally, remember to take the name "emergency fund" literally. Don't dip into it every time you feel like a vacation or a shopping spree. Instead, enjoy the comfort of having this security blanket at the ready if you really need it.

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