David Bach, author of The Automatic Millionaire
Before we get to the tips, most people agree that building an emergency stash of cash that can last long enough to cover three to six months should be one of the first financial priorities, even for those in debt. This can be difficult to achieve. Bach says the average American has less than one month’s worth of expenses set aside.
Here are some tips for getting to the three to six months point:
- Make it automatic. Every time you get paid, a portion should be automatically transferred to your savings account. This is even easier if you have Direct Deposit. If you don’t have this set up yet, just call your bank to get started. At this point, I automatically deposit 5% of my paycheck into a fund for emergency savings, in addition other amounts for other savings goals.
- No checking accounts. Your emergency fund should not sit in a checking account where it can be easily accessed by checks, debit cards, and ATMs. You shouldn’t be able to dip into the fund whenever you feel like. If you do, it’s not really an emergency fund.
- Put it in the right place. Bach suggests a money market account instead of a savings account. There is really no difference unless you’re looking at a “money market fund.” Money market accounts are insured by the FDIC and have no discernable differences from savings accounts. In fact, many banks that offer money market accounts call them savings accounts. The point is to find a cash account that offers significant interest. Here’s a handy guide to the best savings account interest rates.
- Decide how big a cushion you need. As I mentioned above, the typical emergency fund should be three to six months’ expenses. In order to determine what your number is, you have to know what your expenses are. You might have to track your spending for a few months before you have an idea of how much you are really spending. Get help from Quicken or Microsoft Money
Take a look at some of the other blog entries I’ve written on this topic, listed below.
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How the heck can something be LIQUID enough to be considered an emergency account, but be ILLIQUID enough to not “be easily accessed by checks, debit cards, and ATMs”? With on-line banking the difference between a savings account and an ATM machine is a click away.
I’ve never understood the point of an emergency account and I don’t maintain one.
In a true emergency I would call upon friends, family, employer, and available credit to help me out
- not on some $10K$20K that I’ve kept inefficiently invested forever.The slight difference is that the cash will be outside of the ordinary, daily use account. It’s a matter of temptation for some people, and I would think that different people have different levels of resistance to temptation. That’s the reason for not leaving the funds in an almost-perfectly liquid account.
It’s great to have friends and family to help you out in the case of an emergency. Not everyone has or would want to use those resources… and available credit can be an expensive proposition for some people, especially in an emergency with an undefined ending point.
If you have $10k invested at 5% instead of in the market at 8-10%, it’s a guaranteed opportunity cost of at least 3%. If you end up in an emergency and using available credit for that 10k, it’s at a cost of your home equity interest rate, or worse, a credit card interest rate.
There’s no one-size-fits-all solution. Personally, in an emergency, I can call on my cash, which will probably cover about 3 months or more if I reduce expenses.
If I need more, I can tap into my Roth IRA contributions, though I’d rather not. Credit cards and taking money from friends or family would be the last option on my list. It’s a personal choice.