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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 and saving it for a rainy day can help you cope with these types of demands without going into debt or missing bill payments.

Beyond just helping you through a short-term crisis, emergency funds can also become building blocks for good financial habits that will contribute to your wealth throughout your life. This guide will take you through 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 and need help paying bills, 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. 

Having a ready reserve of money can help you deal with the unexpected without taking on credit card debt with high interest rates added on. Here are some examples of when you might need emergency funds:

Pay for car repairs

From a flat tire to a blown transmission, the cost of car repairs can easily be a shock to the average person's budget.

Make medical bill payments

Even with health insurance, co-pays and other payments within your deductible can get quite pricey, and some treatments are not covered at all.

Replace necessary technology or 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.

Use as income after a 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.

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 tips for how to save money fast and build your rainy day fund:

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 with good saving habits

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 several suggestions:

Savings accounts 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.)

Checking accounts

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.

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.

More from MoneyRates.com:

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Your responses to ‘Building an emergency fund’

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